Index Funds Explained for Long-Term Investors.

How Do Index Funds Work?

An index fund pools investors' money and invests it according to the rules of the index it is designed to track. The fund may hold all of the securities in the index or use a sampling or optimisation approach to achieve similar exposure.

For example, if a fund tracks a broad equity index, it may hold shares in many companies represented by that index. The weighting of each company can depend on the methodology used by the index provider.

What Does Passive Investing Mean?

Passive investing generally means following a predetermined investment strategy rather than continuously attempting to identify securities that will outperform a benchmark. An index fund is one of the most common examples of a passive investment strategy.

This approach can reduce the amount of active security selection required by the investor. Instead of deciding which companies to buy individually, the investor chooses an appropriate index and fund and accepts the performance of the underlying market, less applicable costs and tracking differences.

What Is an Index?

A market index is a measurement designed to represent the performance of a particular group of securities. Different indices can represent different countries, regions, company sizes, sectors, asset classes or investment characteristics.

A broad index may include hundreds or thousands of companies, while a specialised index may contain a much smaller group. This distinction matters because diversification and concentration can have a significant effect on investment risk.

How Index Funds Generate Returns

The return from an index fund is linked to the performance of the assets it holds. If the underlying index rises, the fund will generally aim to rise by a similar amount before considering fund expenses and tracking differences.

If the underlying market falls, the index fund will generally fall as well. This is an important difference between investing and saving: investment values are not fixed and returns are not guaranteed.

Accumulating and Distributing Index Funds

Some index funds distribute income generated by their underlying investments to investors. Other funds reinvest income within the fund. These are commonly referred to as distributing and accumulating structures.

The appropriate choice can depend on the investor's goals, account type and tax circumstances. Investors should understand the specific fund structure and its treatment of income before investing.

Index Fund Costs

Costs are an important consideration because even relatively small annual charges can have an effect on long-term returns. Investors should compare the fund's ongoing charges and also consider platform, transaction and other applicable costs.

• Ongoing fund charges
• Investment platform fees
• Trading or dealing costs
• Bid-ask spreads where applicable
• Currency conversion costs for overseas investments
• Taxes and account-specific charges where applicable

Tracking Difference

An index fund aims to follow its benchmark, but it may not perfectly replicate the index's return. Fund expenses, transaction costs, tax treatment, portfolio management and the fund's replication method can contribute to differences between the fund and the benchmark.

When comparing index funds, investors should therefore consider historical tracking performance rather than focusing only on the headline fund charge.

Are Index Funds Safe?

Index funds are not risk-free. The risk depends on the investments represented by the index. A diversified global equity index fund has a different risk profile from a narrowly focused sector index fund or a fund tracking a volatile emerging market.

Diversification can reduce dependence on a single company, but it cannot prevent losses during a broad market decline. Investors should consider their investment horizon, capacity for loss and financial objectives before investing.