Index funds explained
Stripping away the jargon, we look at what index funds are and why investors may typically consider buying them.
Picture the scene. It’s a wet weekend and, finally, you’ve got some time on your hands. But trawling through a long list of funds, all sorts of jargon leap out at you. Is index investing the same as passive investing? And what is a benchmark?
Let’s start with some basics.
Facts about index funds
- Index funds are designed to mirror the performance of an underlying benchmark. A benchmark is a standard by which other things can be measured (examples appear below)
- Index funds tend to be cost-effective because they’re managed in a completely different way from active funds which are managed on a day-to-day basis by investment professionals, also known as fund managers
- For index funds, however, you will pay some management, operational and administrative costs
- Index funds are also known as passive funds, although we typically avoid this term. This is in part due to the approach we take to responsible investing across all our funds which have environmental, social and governance (ESG) issues at their core
- By including ESG factors into investing we aim to ‘do good’ by trying, for example, to tackle climate change and by talking to companies about reducing pay inequality or increasing gender diversity in the workplace
Examples of benchmarks
- An example of a benchmark could be the FTSE 100 index. This is a share index of the 100 largest companies listed on the London Stock Exchange
- Another benchmark example could be the S&P 500 index, which comprises 500 of the largest US companies listed on the New York Stock Exchange
Why is there a difference between the performance of an index fund and the benchmark?
- With index funds, the difference between the fund and benchmark may be on account of the costs you’re paying
- The difference may also be due to what type of index fund you hold
- For example, as we describe above, some index funds may exclude certain holdings for (ESG) reasons and are therefore ‘adding value’ in our view. You can learn more about responsible investing, which has ESG factors at its core here
- You need to be clear from the start what your index fund is trying to achieve. You can usually find this information in its factsheet on the website
Why investors may like index funds.
Cost effective. Index funds can be a relatively inexpensive way of accessing financial markets. Lower costs mean you are potentially eating less into any profits you may make from your investment
Many holdings. The benchmark you choose to mirror includes many holdings. This way you are diversifying your risk. In other words, you’re avoiding putting all your eggs in one basket.
Simple. The aim of an index fund is fairly simple – to mirror a benchmark’s performance before costs. Costs may include management fees, operational fees and administrative fees.
Why investors may not like index funds.
Little individual choice. As you have bought a basket of investments, you’re not usually able to choose which individual investments you may want to buy.
Slimmer returns. Index funds are not usually designed to beat their benchmarks. Do not generally expect excessive returns from this type of investment.
Limited protection. In the event of a market fall, index funds are unlikely to cushion you against the decline, simply because they are designed to mirror the performance of financial markets.
Hopefully now, when you visit our fund centre, you’ll know what some of the terms such as index, passive and benchmark mean.
Remember, the value of any investment is not guaranteed. The value of investments and any income received from can go down as well as up and you may not get back as much as you had originally invested.