Investing in index funds: What you need to know

Index funds, also called investment funds in the UK, are types of mutual funds or  exchange-traded funds (ETFs). They are investment portfolios which attempt to match a single financial market index. Generally, index funds outperform other types of mutual funds over longer periods of time. But are index funds right for you? Loqbox is here to help. (Don’t be put off by the jargon, we’ll dive into what some of these terms mean in just a moment!) 

If you’re just beginning to think about investing — or you’re just getting started — read our blog on how to invest in stocks and shares for beginners. 

What is an investment fund or index fund?

So, maybe you've heard about investing in index funds, but what exactly are they? Simply put, an index fund is a bunch of stocks or bonds that track a specific market index, like the FTSE 100 in the UK. 

The Financial Times Stock Exchange 100 Index  — or “FTSE 100” for short — is the share index of the 100 largest companies listed on the London Stock Exchange (LSE). To be on the list, a company must meet some minimum requirements,  be listed on the LSE,  and offer shares in their company in pounds (GBP). Many traders and investors view the success of the FTSE 100 as an important indicator of the health of the UK economy and stock market. 

When you invest in an index fund, your money is invested in a group of shares that aim to “track” the success — or failure — of a whole market index. Rather than having your investments managed by a number of fund managers,  who choose which shares to invest in, your investments are usually spread across a broad range of assets in a single and simple fund, without having to pick individual stocks.

Index funds are a type of mutual investment fund. These investments bring together pots of money from various individual investors into shared portfolios with the hope of building a mutual advantage. This is different from Exchange Traded Funds (ETFs), which are usually individual portfolios. However, each type of fund passively follows specific financial market indices rather than being actively managed.

How does an index fund work?

Investing in an index fund is a bit like picking from a buffet rather than choosing a single dish —  you get to taste a bit of everything. 

Because index funds mirror the performance of an entire market index, your investment is spread across various companies. This diversified approach aims to minimise risk and maximise your potential returns. But it’s very important to remember that your investment could go down, rather than up. 

With an index fund, your money contributes to a passive and mutual investment alongside other investors. The index fund will then buy shares in all the companies within a single financial index, or at least a representative sample of bonds if there are too many companies within the index.

Pros and cons of index funds

Because index funds track the performance of a financial market index, they passively follow it regardless of whether it is going up or down. Therefore, you can risk getting less back from your investment than you originally put in. You don’t have the control to try and beat the market.

But investments are always a risk. If you want to take bigger risks, and potentially get even higher returns, active investment funds may be more suited for you. But index funds are great if you want a more hands-off approach. 

Let’s take a look at the good and the bad of index funds:

Pros:

• Easy diversification: Diversifying your portfolio is often considered a good idea when investing because it helps reduce the risk of losing your money. Index funds make it easy to do this because they allow you to buy multiple shares across various companies all at once.
• High returns, low fees: Passive index funds often provide higher returns than actively managed funds over longer periods. Also, because they stay consistent across their duration, the trading costs and fees for running them will usually be lower than actively managed funds.
• Long-term growth: Patience is a virtue in the world of index funds. They're ideal for long-term investors aiming to grow their wealth steadily over time. This means they are sometimes considered a good option for retirement accounts.
• Low time and effort costs: If you want to invest money, but you don’t want the hassle of picking which shares, an index fund can take the responsibility out of your hands. This is great if you don’t trust your financial knowledge and instincts. Index funds make investing more accessible for all of us.

Cons:

• Low flexibility: Index funds don’t offer a great deal of flexibility, because they only track one financial market index. If that market is underperforming, you can’t change those stocks, only sell them.
• Limited control: Because index funds are mutual and passive they are naturally more hands-off than actively managed, individual funds. No fund manager is controlling your portfolio. That means you will have fewer options if the market is underperforming.
• Can’t beat the market: As mentioned above, an index fund is passive and mutual, with no fund manager changing and controlling the investment. That means your investment is heavily tied to market fluctuations. If the index is failing, you can’t actively work your investment to beat it.

What are the risks of index funds?

Before diving into any investment, consider your financial goals, risk tolerance and investment timeline. Index funds can be a convenient “set-it-and-forget-it” strategy, but understanding your personal preferences is key. Does a long-term, low-risk, and hands-off approach suit your investment ambitions? If so, index funds could be perfect for you.

While generally considered low-risk, it’s important to say that index funds aren't immune to market fluctuations. Economic downturns can impact an entire market, including your index fund. However, their diversified nature helps to cushion the blow.

Is saving a good alternative to investment funds?

Saving your money can be a safe and sturdy option, but the growth potential is far lower than an investment with a good return. Index funds can potentially outpace inflation, but they can be risker than traditional savings accounts because growth isn’t guaranteed.

If you’re uncomfortable taking risks but want to maximise your savings pot, you might want to consider investing in a high-interest savings account instead. 

Before you start thinking about investing, it’s often worth thinking about your overall financial health. Think about your current financial situation, and ask yourself the following questions: 

• Do you have any existing debts you might need to pay off before you think about saving or investing? 
• Do you have emergency savings set aside that you could rely on if your investments decreased in value?
• Are any of your other goals — like learning how to manage your budget, or building your credit score — more of a priority at the moment? 

How to invest in index funds

So, if they fit your risk levels and timescales, you might now be wondering how to invest in mutual funds, like index funds. You might also be wondering what the best funds to invest in 2024 are. Loqbox has some simple tips:

• Research: Learn about different index funds, their performance history, and the markets they track. The market is ever-changing, but some funds consistently shine. Look for reputable investment providers, and make sure that they’re regulated by the Financial Conduct Authority (FCA).   
• Select a platform: Choose a reliable investment platform to start your journey. Many providers offer apps or online investment management. 
• Diversify: Don't put all your eggs in one basket. You can spread risk even further by choosing a mix of funds.
• Regularly review: While index funds are low-maintenance, it's good practice to review your portfolio every once in a while to ensure it stays in line with your goals.

We hope that you’re feeling more informed about  investing in index funds. Index funds can offer low-risk, low-effort, low-cost investment opportunities, but it’s important to consider your financial situation before you take the plunge.  If you’re unsure, consider speaking to a financial advisor.