Index funds explained

Most investing advice sounds like it was written to make you feel you need help. Index funds are the awkward exception: an idea so simple that it's mainly interesting for what it doesn't try to do.

An index fund doesn't try to pick winners. It buys the whole list.

What an index is

A market index is a list of companies with a rule for who's on it. The FTSE 100, the example the FCA uses, is one. Others cover a whole country's market, a region, one industry, or companies across the world. The index's value goes up and down with the prices of the companies on its list, so it works as a scoreboard for that slice of the market.

An index is just a measurement. You can't buy one directly. You can buy a fund that copies it.

What an index fund does

An index fund, also called a tracker fund, holds the companies on an index in roughly the same proportions as the index itself. When the index rises 5%, the fund aims to rise about 5%, minus its costs. When the index falls 5%, so does the fund.

The FCA describes tracker funds as taking a passive approach, aiming to match the performance of a market index. Nobody in the fund is deciding which companies look promising this year. The index decides, and the fund follows.

Active funds, for comparison

An active fund pays a manager and a research team to choose investments, aiming to do better than an index such as the FTSE 100. The FCA notes that this kind of outperformance is not guaranteed. Some active funds beat their index in a given year; some don't. Either way, you pay for the attempt.

Why the cost matters so much

Every fund charges a yearly fee, taken as a percentage of what you hold. You don't get a bill. It comes out of the fund quietly, which is exactly why it's easy to ignore.

According to the FCA, the management charges for tracker funds are typically lower than for active funds. That makes sense: copying a list is cheaper than paying people to second-guess it.

A gap of a percentage point a year sounds trivial. It isn't, because charges compound just like returns do. Here's an illustration using our own compound interest calculator, with made-up numbers rather than a forecast:

• £100 a month for 20 years, growing at 5% a year after charges, ends at about £41,103.
• The same £100 a month, but with charges a point higher so it grows at 4% a year, ends at about £36,677.

Same money in, same market, and a difference of over £4,400, all of it from charges. The FCA's own warning is that charges can mount up over time and eat into your returns.

There's more than the fund's own charge to check, too. The platform or ISA provider you hold the fund through usually has its own fee, either a percentage or a flat amount. The total is what you actually pay.

What "tracking" costs you

An index fund won't match its index exactly. Its charges come off the top, and the practicalities of buying and selling hundreds of companies mean small differences creep in. Over a year, a well-run tracker should end up close to its index, minus roughly its costs. If one drifts a long way from its index, that's worth asking about.

Diversification in one purchase

The other big point in favour of index funds is spread. Buying one fund that tracks a broad index gives you a small piece of every company on the list, whether that's 100 or several thousand.

The FCA's golden rules put it this way: spreading your money across different companies, asset types and geographical areas reduces your reliance on any one to perform. It also notes that most people who invest choose funds that spread risk across companies, industries and countries.

If one company in a broad index collapses, it's one entry on a long list. If it was your only investment, it's the whole story.

But an index can be narrow

Not every index is broad. Some cover one country, one industry, or a handful of the very largest companies. A fund tracking a narrow index is only as spread out as the index is. "It's an index fund" tells you how it's run, not how diversified it is. Check what's on the list.

What an index fund can't do

The FCA's view is that the higher the potential return, the greater the danger of things going wrong, and that investing for at least five years gives your money more chance to ride out the dips. That's the deal with index funds: you accept the market's bad years in exchange for its long-run growth, at a low cost.

The FSCS protects investments up to £85,000 per person, per firm if an authorised firm fails, but it can't accept claims for poor investment performance. A falling index is not a claim.

Holding one in practice

Index funds are usually bought through an investment platform, often inside a stocks and shares ISA, where there's no tax on income or gains, or inside a pension. The FCA suggests regular investing, such as every month right after payday, and notes that staying invested rather than moving in and out helps keep costs low.

Before you buy any fund, the FCA's five smart checks are a sensible filter. Will you need the money soon? Do you understand how this works and what it costs? Is the risk right for you? Does it spread your money? And what if it falls in value?

An index fund answers the middle three fairly well. The first and last are up to you.