Index funds and ETFs: a beginner’s guide

Index funds and exchange-traded funds (ETFs) are two of the easiest ways to begin investing in the stock market.

They can outperform higher risk investments in the long term, remove the hassle of picking specific stocks, and even Warren Buffet believes they’re a savvy option.

However, they’re not without risks. Here’s an introduction to these investment vehicles.

What are index funds and exchange-traded funds?

Index funds and ETFs are types of mutual funds that allow you to invest your money in more than one security (‘securities’ is a blanket term for the range of assets that includes stocks, shares, and also bonds).

Indices measure the price of a so-called ‘basket of securities’ (anything that has interchangeable value).

They can either have a specific focus or measure performance across a broad range of markets and sectors.

The index fund aims to match the market performance of its index as closely as possible.

The key distinction between index funds and ETFs is when they can be bought and sold. Index funds can only be bought at the price set at the end of the trading day.

Their value won’t fluctuate throughout the day as individual stocks do. ETFs, however, can be traded in the same way as stocks, and you’ll get a different price depending on the time of day and market conditions. 

Things to know before investing in ETFs and index funds

While index funds and ETFs are generally considered a low-risk investment, this is only when compared to individual stocks & shares.

They are still higher-risk than cash or government bonds, in that you can still lose money.

Broad market funds’ diversity will cushion investors from sector-specific market shifts, but if the stock market as a whole plummets, index funds and ETFs will too.

Neither option is immune to stock market crashes, particularly if they’re on the scale of those seen in 2008 and early 2020.

Then again, all investment carries risks. The important thing to bear in mind is the trade-off between risk and potential reward.

Higher risk means higher possible rewards, while lower risk generally means less opportunity for growth.

The important thing is to work out your own risk tolerance and invest based on how much you can personally afford to lose.

Remember too that not all index funds and ETFs are equal, and some are best avoided.

Beware of those who use computer-generated back-testing as their primary indicator of market performance, rather than tracking an index based on its actual, current performance.

A barrage of new index funds and ETF products has entered the market in the last decade, as more and more investors rush to capitalise on the potential of these investment products. 

Learn more: what's the difference between ETFs and index funds?

Pick funds that reflect your investing strategy

Most people looking to invest in index funds for the first time may be drawn to funds that track major indices such as the Standard & Poor’s (S&P) 500, the Dow Jones or the FTSE 100.

This stock market index tracks the performance of 500 of the US’s largest companies across a broad range of sectors.

The S&P 500 index funds’ value will rise and fall in line with the stock market.

The diversity of these broad market funds can protect investors from sector-specific crashes, which is why they’re considered a lower-risk investment.

On the other hand, index funds may place an upper limit on how well your investments can do. You won’t reap the benefits as you would from traditional stocks if one company or sector surges in value.

Sector-specific index funds

Investors seeking big returns (at higher risk) might find that sector-specific index funds and ETFs are suited to their goals.

If you have plenty of stock market knowledge, you can pick and choose which ETFs to invest in.

Again, broad market index trackers tend to offer safe, steady returns, so they’re the best bet if you’re seeking a low-risk investment that can steadily grow.

The best EFTs to invest in will change regularly, but providers such as Vanguard and iShares and SPDR offer some of the largest and most well-established options.

Learn more: Vanguard vs Blackrock

ETF model portfolios

Alternatively, you can invest in an ‘ETF model portfolio.’

This option is made up of a number of ETFs, or a mixture of ETFs and index funds, which have been selected by a stockbroker.

You can choose between sector-specific and broad range ETFs and go for a growth option (if you’re happy to wait for a return) or an income option.

Model portfolios are a good choice if you’re looking to invest in more than one ETF or index fund.

Thematic investing

If you’re interested in a particular market or cause, or are seeking ethical investments, you could also look into thematic investing.

Popular and established thematic investment trends include clean energy, climate change and disruptive technology.

Essentially, a thematic investor will pick ETFs or index funds that fit a theme that’s predicted to be profitable in the future.

You’ll probably need a stockbroker to help you with this strategy.

Factor in ongoing costs

Virtually all index funds and the majority of ETFs are passively managed, meaning the investments made by the fund are based on an index, rather than the active judgement of a broker.

As a result, they can be much cheaper to invest in than mutual funds, for example.

However, you’ll still have to pay an annual fee to cover the admin costs of the index fund.

The average expense ratio (the amount investors are charged for investing) of passively managed funds is currently around 0.12%, compared to 0.5% to 0.75% for actively managed funds.

You’ll also have to pay a commission every time you buy or sell an ETF.

That’s not a huge issue if you’re investing for the long-term, but intraday traders could find these small fees add up with a very liquid portfolio.

And finally, you’ll need to check if your chosen ETF distributes capital gains (profits from sales) among shareholders, as you may be liable to pay capital gains tax.

You can avoid this by investing in an ETF that retains and reinvests capital gains.

Invest via your chosen platform

If you’ve invested regularly before, you can invest in index funds or ETFs via a brokerage account.

ETFs generally have much lower minimum investment requirements, so they’re a good choice if you don’t want to invest tens of thousands.

Index funds generally require you to invest a minimum of a four-figure sum to get started, though most brokers will allow you to top it up in the future with smaller amounts.

Here are four of the most popular investment platforms you could consider:

1. Bestinvest

Bestinvest is a low-cost platform that’s well suited to beginners.

Users can choose from ready-made portfolios of stocks and shares, or can choose to build portfolios of their own.

The platform charges £4.95 for buying and selling shares, and there is also an annual fee, which can be up to 0.4% depending on how you are investing.  

2. Interactive Investor

The second-largest investment platform in the UK, Interactive Investor lets users buy shares on stock markets around the world.

The platform has a range of subscription plans available for investors, ranging from £4.99 per month to £19.99 per month, as well as a £3.99 buying and selling fee for US shares and a £5.99 or £9.99 fee for international shares, depending on the subscription level you choose.  

3. AJ Bell

AJ Bell offers ready-made investment plans in addition to letting users choose their own investments.

There is an annual platform fee which can be up to 0.25%, as well as a share dealing fee starting at just £1.50 per deal.  

4. Hargreaves Lansdown 

Hargreaves Lansdown helps investors of any experience buy and sell shares in the UK and international markets.

Like many other investment platforms, you can choose from pre-set investment funds, or you can choose your own investments.

Hargreaves Lansdown charges a dealing fee which changes according to how many deals have been done in the month prior, and 0.45% on its stocks and shares individual savings accounts (ISAs) up to £250,000. This fee is lower for those with more assets and is capped at £45 a year. 

Get expert financial advice

Index funds and ETFs offer an accessible and versatile way to invest because they cater to various investment strategies and risk appetites.

Whether you opt for the stability of broad market funds, the targeted approach of sector-specific ETFs, or the innovative angle of thematic investing, these tools can help you build a diversified portfolio.

While they carry some risk, especially during market downturns, they remain a popular choice for those looking to grow their investments over time.

As with any investment, it's crucial to align your choices with your financial goals and risk tolerance.

With the right approach, index funds and ETFs can be a valuable addition to your investment strategy.

Unbiased can connect you with an expert financial adviser who can guide your investment decisions and ensure that you maximise your returns, both in the short and the long term.