Index funds and ETFs: a beginner’s guide

Index funds and ETFs (exchange traded funds) are two of the easiest ways to begin investing in the stock market. They can out-perform 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 is an index fund/exchange traded fund?

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). Indexes measure the price of a so-called ‘basket of securities’ (anything that has interchangeable value) and 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 for the price set at the end of the trading day. Their value won’t fluctuate throughout the day as an individual stock’s would. ETFs, however, can be traded in the same way as stocks and you’ll get a difference 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 personally can afford to lose.

Remember too that not all index funds and ETFs are equal, and some are best avoided. Beware of those that 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 have 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 will be drawn to funds that track the Standard & Poor’s (S&P) 500. 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, S&P 500 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 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, iShares and SPDR offer some of the largest and most well-established options.

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 the 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 EFTs 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 0.15%, compared to 0.67% for actively managed funds. That means for an investment pot of £10,000, you’d pay around £150 in fees every year if you chose to invest in something like an index fund or ETF.

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 (typically under £10) 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 a number of times 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 at minimum a four-figure sum to get started, though most brokers will allow you to top it up in the future with smaller amounts.

Consult an independent financial adviser

Speaking to an IFA is a sensible first step, whether you’re new to investing or not. If you have limited investment experience, an IFA will advise you as to whether index funds or ETFs are going to suit you. They’ll find out how open you are to risk and potentially losing the money you invest and whether you’re looking for long, medium or short-term investments, among other factors that determine where you should invest.