Index funds are a type of mutual fund that is becoming very popular due to its simplicity and high returns.
In my opinion the best way to start investing in the stock market is through index funds. Actually, my first ever investment was in index funds back in 2015.
In this guide you will learn why index funds are the best way to accumulate wealth.
- What are index funds?
- Advantages of index funds
- Index Funds characteristics
- Differences between ETF and index fund
- Index funds or mutual funds?
- Best index funds to invest
- How to invest in index funds
- How do I invest in index funds?
What are index funds?
If you haven’t heard of index funds, you’re probably wondering what is an index fund. If we ask our friend Wikipedia:
An index fund is designed to follow certain preset rules so that the fund can track a specified basket of underlying investments.
In summary, index funds are mutual funds that copy a stock market index. Since they just track an index they do not require active management. That is why index funds are known as passive investment.
The most popular index funds track indices such as S&P 500, FTSE 100 and Dow Jones Industrial Average. The popularity of index investment is growing, and thanks to this there are more and more index funds.
Advantages of index funds
Index mutual funds are one of my favourite investment products. In fact, I consider them the best way to start investing for a new investor. I have totally fell for them. If you keep reading I will tell you all the benefits of investing in them.
Index funds have very low fees. This is because, unlike traditional investment funds, they do not need active management.
Traditional mutual funds have a team of financial analysts who choose the companies they expect to have a great performance in the future. This means higher costs in order to cover the cost of the analyst team.
Index tracking funds are very simple, they do not require any analysis. They just have to copy the composition of the index they want to replicate. Thanks to this, their commissions are much lower.
Index funds fees are on average 10 times lower than mutual funds fees.
Saving money on fees has huge long-term consequences. Right now saving 1% on fees per year may not seem much, but that 1% accumulated over several years has a great impact on the value of your investment portfolio.
Later, in the section “Index funds or mutual funds?” I give you a clear example of this. I recommend you to read the entire guide, but if you want to jump to that section click here.
The expense ratios of the index funds are very low. For example, I invest in a Vanguard fund that tracks the S&P 500, which has an expense ratio of 0.07%. Isn’t a 0.07% annual fee great? 🙂
Index funds can give you great returns. Since they track a market index, their return depends on the performance of the index they replicate.
The best example of its high returns is to take a look at the S&P 500, the most popular stock index in United States, and probably in the world.
The S&P 500 has obtained an annual return of 10% in the last 63 years. Yes, you read it right. 10% return! Just by investing periodically in a fund indexed to the S&P 500 you would have obtained a 10% return.
If you want to learn more about the evolution of the S&P 500 price take a look at this article.
Not all index funds are going to get these great results. That is why it is important to review properly a fund before you invest your money.
It is important to note that past returns do not guarantee future returns. Earnings will depend on the type of index fund you choose, your time horizon, and your investment strategy.
Investing in index funds is easy, it requires very little work on your side. It depends on your investment strategy, but it can usually be 5 minutes per month.
If you want comfort, investing in index funds is the easiest thing in the world. There are investment platforms that will do everything for you, they are called robo advisors.
Robo advisors design your investment portfolio based on your experience and risk tolerance. They take care of buying the assets and balancing your portfolio when necessary.
A robo advisor does all the work for you. You just have to transfer the money to your investment account, and they will take care of everything. The best robo advisors in UK are Nutmeg and Moola. My preferred robo advisor is Nutmeg, which offers you a great variety of investment portfolios with very low commissions.
In my opinion it is one of the best ways to start investing. If you want you can see the portfolio Nutmeg designs for you here
Being a simple product that doesn’t require management on your part, you don’t have to do much You just have to send your money to the platform, something that will take you just 5 minutes.
How about a good return for 5 minutes of work? 🙂
Index Funds characteristics
Now I am going to cover the main data you should check on an index fund before you invest in it.
Index funds are usually invested on stocks and bonds, but they can track any index, even Real Estate. Equities usually give higher returns, but the risk you assume is bigger. On the other hand, a bond index usually offers lower returns, but you also take less risk.
I prefer to invest in equity index funds, since the return is much higher in the long term.
The fact that one year it could go down 20% does not concern me, because I know that the next year it will rise again. As you can see, my risk profile is high, since I prefer to obtain high returns.
One important data to check on an index fund is its tracking error. This is the difference between the performance of the index and the performance of the index fund. It allows you to compare different funds and identify which one is performing the best. The lower the tracking error the better the fund is replicating the index.
You should also review the index fund fees, since they vary greatly among the different fund manager companies, such as Vanguard, Charles Schwab and Fidelity. I recommend Vanguard index funds, since their fees are very low. Also, I’m a big fan of John Bogle, the founder of Vanguard.
Differences between ETF and index fund
If you have been looking for information on index funds, you have surely come across ETFs, but you have not understood very well what they are.
The name ETF comes from Exchange Traded Funds. ETFs are very similar to index funds, but they have some differences.
The main one is that index funds are not constantly traded. Its price is established once a day, and it applies to both purchases and sales.
On the other hand, ETFs are traded on the stock markets, so their price changes constantly. You can set the price you want to buy an ETF, but you cannot set the buying price for an index fund.
In terms of capital gains tax, there is no difference between investing in ETFs or index funds. You will pay the same taxes. Overall, ETFs are becoming more popular because some people find it better trading directly ETFs. But in my opinion there is not much difference.
Index funds or mutual funds?
Index funds get their name because they copy the behaviour of an index. Unfortunately in United Kingdom they are not yet very well known.
Banks had until very recently the whole investment business, and they recommended to their clients to invest in mutual funds. These funds have much higher fees, and do not usually get a better return.
In fact, I have seen cases where the mutual fund return was 2% per year, and the fees were 2%. The small profits generated by your investment were kept by the bank.
This happens due to the lack of financial education, and the greed of banks to earn more money at the expense of investors. I hope this makes you realise that when it comes to investments you cannot trust what your bank tells you, you have to do your own analysis.
Fortunately, in recent years, alternative investment platforms have emerged, with which the regular investor can obtain good returns paying low commissions.
Index funds are better than mutual funds due to their low fees and high returns.
The main difference between index funds and mutual funds is that mutual funds are actively managed funds. The fund managers do research on the companies that will obtain better results in the future, in order to invest in them.
This work has a cost for the investor, which is reflected in the high commissions the investor pays.
On the other hand, in index funds the figure of the fund manager does not exist. The index fund just needs to mirror the index, and that with today’s technology requires little work. That’s why the fees on index funds are so low.
I imagine that now you might be wondering: Do higher fees have so much impact in my portfolio? Yes, a lot 🙂
Example of the impact of high fees on your portfolio
Now I am going to show you an example of how the mutual funds fees can have a huge impact on the value of your portfolio.
We have John and Paul, both invest 10,000 pounds in funds. But while John invests in index funds, Paul prefers his bank’s mutual funds.
Let’s assume that both get a 10% annual return (a good return). John pays 0.1% on annual fees, while Paul pays his bank 1.5% a year.
Let’s see what happens over time
After 30 years, John has 54,000 pounds more than Paul. He has made 47% higher profits thanks to the low fees of its index fund.
What do you think of the impact of paying high fees? Simply brutal. I hope now you understand the importance of investing in low cost index funds.
Do mutual funds have higher returns?
You may be wondering if the high fees charged by mutual funds are due to the higher return obtained, and therefore it is worth investing in mutual funds.
The answer is no, not at all. I have already given you the example of a mutual fund where the annual return was 2% and the fees they charged were 2%. Something that at first glance seems crazy, a deception. But it happens today in many banks.
Don’t worry, you don’t have to take my word for granted. Several studies have confirmed that in the long-term index funds obtain higher returns than mutual funds.
One of them focused on comparing the performance of US mutual funds with the S&P 500 index. The table below shows you the percentage of investment funds that performed worse than the S&P 500 over time:
In 15 years 92.4% mutual funds obtained worse returns than the S&P 500. This study shows that the probability of choosing an investment fund that outperforms the S&P 500 in the long term is only 7.6%.
The bottom line is that mutual funds charge you much higher fees than index funds and their returns are lower.
If you select individual stocks, it is very likely that you will be outperformed by the S&P500. Stock picking, buy and sell companies, might be fun, but it’s not profitable. Individual investors will most likely obtain higher returns by investing in index funds.
If you want to read more about this topic, take a look at this article.
Best index funds to invest
If you are wondering about which are the best index funds in UK, you are on the right place to find that out.
There are many index funds available, so it’s important to know which will have the best performance. In my opinion, the best index funds are:
- S&P 500: the New York index contains the 500 largest companies in the United States
- MSCI World: roughly 1600 companies from 23 developed countries
- FTSE 100: top 100 UK Companies
The above funds are among the world indexes most traded.
My favourite is the S&P 500 Index, since it has averaged a 9% return over 150 years. When something has worked well for so long, it is more likely to continue working well in the future. In 2019 the S&P 500 obtained a return of 30%, not bad at all!
If you are planning to create a portfolio of index funds, I recommend that you use the 3 funds above to build a well diversified portfolio. You don’t need more diversification, since these funds cover companies from many countries around the world.
How to invest in index funds
You can invest in index funds through a broker or through robo advisors, depending on the type of investment you want to make. Let’s see the characteristics of each one.
You can get access to index funds through brokers and investment platforms. If you want to design your own portfolio, choosing the ones that you think will obtain the highest return, then you must go to a platform that offers you a wide range. In UK my favourites are DEGIRO and Hargreaves Lansdown.
I recommend that you start with DEGIRO, which allows you to invest in more than 200 ETFs without paying fees.
DEGIRO is one of the best brokers to invest in stocks and index funds with very low commissions. You can learn more about this broker on my super guide of DEGIRO.
If you want to start investing in the 3 best index funds with DEGIRO sign up here.
Unfortunately the DEGIRO website has currently frozen the opening of brokerage account for new users. This is because with the Covid-19 crisis their workload has increased and they have had to temporarily implement this measure.
You can sign up for DEGIRO, and they put you on a waiting list. They expect to start processing new users on the first week of May. I will keep you updated as soon as I learn something 🙂
If you want to invest in index funds through ISAs and SIPPs, then I recommend you to use Hargreas Lansdown, a great investment company. Take a look at my mega-guide about Hargreaves Lansdown.
This is the most comfortable way to invest. Roboadvisors design an investment portfolio that suits your investment profile, taking into account your experience and risk tolerance.
You reduce the risk since they design the portfolio for you, choosing the funds that best suit your investment profile. They also usually balance your portfolio automatically.
All you have to do is transfer money and they take care of everything. It is a really comfortable method that reduces risk, so you can gain experience investing in the stock market little by little.
I recommend investing with Nutmeg, which allows you to open an ISA, Personal Pension Plan (SIPP) or general investment account with a minimum investment required of 500 pounds. You can access all their accounts here.
You can also transfer your existing ISAs or retirement plan (SIPPs) to them, in order to benefit from your current investment plans. They charge you 0.45% annual fee for all their services, and they allow you to access index funds with low fees. That’s why Nutmeg has very good reviews.
In my opinion robo advisors are a very easy and simple way to get you started in investing.
How do I invest in index funds?
I have been investing in index funds for a long time. I started investing in the stock market through index funds back in 2015. At that time I had no idea about investments, it was the beginning of my journey. I had some money on my Spanish savings account and I decided to start doing something with it.
I reviewed the funds my bank offered me, and I decided on three. Fortunately one of them was an SP500 index fund, and over time I saw the high return I was getting.
I currently invest in index funds in the two ways that I have recommended:
- S&P 500 Index Fund: this asset is one of my favourites. The fund tracks the popular Wall Street index, aiming to achieve a 10% annual return over many years
- Robo advisors: I invest in a Spanish robo advisor called Indexa Capital. It is very comfortable and simple
If you want to learn more about where I have my assets invested, take a look at my investment portfolio analysis in April 2020.
A great investment strategy is to make periodic contributions to funds indexed to the S&P 500. If you apply this simple strategy you will get very good results. That’s why Warren Buffett recommends to follow this strategy.
Example of index fund portfolio
Lastly, let me show you how an index fund portfolio looks like. In the table below you can see the different funds that make up one of Nutmeg’s portfolio.
This portfolio has a medium-high risk/reward balance. A more conservative portfolio has more bonds while a riskier portfolio has more equities.
In the picture above you can see that most of the ETFs are equities, which points to a higher risk, and higher return too. There are a few ETFs invested in bonds, an a marginal part (0.3%) in cash. I personally prefer to have a full equities portfolio, since I like to take more risk and obtain higher returns.
Most of the ETFs used by Nutmeg are Ishare and Vanguard, which makes their fees low. This means that Nutmeg can offer you a great service with low cost.
Please remember that investing involves risk of loss.
More articles about investing in stocks
If you want to continue learning about investing and personal finance, I recommend the following blog articles:
- Guide to start investing
- How to invest in the stock market
- Analysis of my investment portfolio in April 2020
- How to save money
That’s all on my index funds guide, I hope you liked it!
If you have any questions about this article, use the comments section, I will be happy to help 🙂