All about Index Fund; nature, benefits, returns & Top five of UK’s Index Funds!

  • A low expense ratio is the main unique selling proposition (USP) for index fund investing as an index fund tracks a benchmark like FTSE 100 or FTSE 250
  • Ideal for moderately risk-averse investors
  • Guards investment portfolio against the individual stock’s sharp volatility (as it is diversified in same proportion as an index)
  • Fund with relatively lower expense ratio would outperform its peers. 

“Index fund investment eliminates the risks of individual stocks, market sectors and manager selection. Only market risk remains.” – John C. Bogle (Founder of The Vanguard Group)

What is an Index fund?

An Index is like a mutual fund that replicates the portfolio of an index. These funds are also known as index-linked or index-tracking mutual funds.

A vast majority of investors are aware of the utility of portfolio diversification across the investable asset classes. Index fund often gains traction for those who are in search of fund that invests in the portfolio of the broader indices-like FTSE 100, FTSE 250, etc. All constituent stocks of the index find representation in the index fund’s investment portfolio. Passive management ensures that the fund replicates the index’s performance, which is being benchmarked. Also, low expense ratio is a key USP for index funds.

Because these are not actively managed funds, these funds incur relatively lower expenses when compared against the actively managed funds. As these do not target to outperform the broader indices, as is the case with actively managed funds, where efforts are initiated in the direction to outperform the broader market returns.  Instead, index funds try to maintain uniformity in asset allocation with respect to the index and fund managers do not bet on generating alpha. They facilitate investors to minimise risks associated with their investment portfolios.

How do Index Funds function?

Typically Index funds gauge a benchmark like FTSE 100. Its constituents will have all the 100 stocks that comprise Footsie, in the same proportion. An index is a portfolio of securities defining a market segment where the underlying could be money market instruments, capital market instruments (bond and equity) and commodities like; gold, silver, oil and others. Some of most prevalent indices of the UK are FTSE 100 and FTSE 250 and since the index funds gauge a particular index, they usually fall under passive fund management. The asset managers decide which stock has to be bought and sold in accordance with the composition of the underlying benchmark. However, unlike actively managed funds they do not require the services of a standalone team of research analysts to figure out different pockets of opportunity in order to beat the returns of the benchmark index.

Contrary to the case of an actively administrated fund which aims to outperform its benchmark index, index funds try to match the performance of its reference index. Typically, an index fund’s performance oscillates around the returns provided by the benchmark index. However, there could some marginal deviation in absolute terms, which is termed as tracking error. Although, fund managers should try as much possible in order to bring down the tracking error.

What kind of investors should vie for Index Fund Investing?

Equity investment is subject to one’s risk appetite and return expectations. The decision to invest in an index fund completely depends upon the investors’ risk preference and financial goals. However, index fund investing is typically ideal for moderately risk-averse investors who are looking out for a normalised risk-adjusted rate of return, rather than abnormal rate of return from their portfolios. Index funds do not require constant tracking. For instance; if you want to invest in equities but do not want to take humongous risks associated with the actively managed equity funds, you can go for FTSE 100 or FTSE 250 index funds. These funds would help you generate returns at par with the broader indices; However, if you are aiming market beating returns then you should go for actively managed funds available in the financial market.

Since index funds trace an index, they are less affected by specific stock-related volatilities and consequently have lower downside risks. Index investing could be significantly beneficial in the midst of a bull market rally, which is founded on strong fundamentals. This strategy carries a potential to deliver premium returns on investments. However, during a bear-market, it would be intelligent to target actively managed funds in order to guard your investment portfolio against any substantial downside risks.

Costs associated with Index Fund Investing

Index fund typically charge a low expense ratio of somewhere around 0.5% or even less in many cases, against an expense in between 1% to 2.5% charged by the actively managed funds. As the portfolio of index funds do not require constant administration and the asset managers are not required to constantly follow or tweak an investment strategy there is substantial difference between the expense ratio of index mutual funds and actively managed mutual funds.

Let us suppose that two index funds are tracking an identical index., Therefore both of them should be able to generate similar returns. However, the fund which is charging a lower expense ratio would be able beat the return of the other fund with a higher expense ratio.

Top five Index Funds of the UK

Choosing a fund requires an investor to analyse the fund from various perspectives and a lot more usually depends upon the future financial commitments of the investors and their life goals. Also, risk appetite plays a crucial role while selecting a fund together with the time horizon.

Below is a list of a top five index funds in the UK. However, it has to be borne in mind that this does not constitute a recommendation in any manner;

  1. HSBC FTSE 250 Index
  2. Vanguard FTSE UK All Share Index
  3. Legal & General European Index
  4. Vanguard US Equity Index
  5. Legal & General Global Technology Index

“Don’t look for the needle in haystack. Just buy the full haystack”. – Jack Bogle