Index Funds in the UK Explained (2022 Edition)

Index funds are collective investment programs that follow the movement of a particular market index. 

Although they are considered the easiest and most popular ways to invest in the stock market, there are still a lot of people who don’t understand exactly what index funds are in the UK and how they work. 

In this article, we will explain everything you need to know about tracker funds and how to invest in them.

What Are Index Funds in the UK?

Put simply, index funds are a portfolio of a select group of securities (stocks, shares, and financial assets) that track the movement of a market index. 

What is an index, though?

An index shows the overall change in the stock market. It is made of a number of shares and stocks and goes up if the aggregate performance of those shares increases. An example of an index is the FTSE 100 which represents the 100 top-performing UK companies. 

So instead of trying to beat the market and have fund managers pick out investments for you, index funds contain passively managed funds allowing you to sit back and reap the benefits. 

Are index funds popular?

Tracker funds are an appealing choice for investors for two reasons. 

Firstly, they allow you to diversify your portfolio as you are investing in many different companies all at once. Secondly, since index funds run on computer algorithms instead of relying on research and costly human managers, they are much cheaper than actively-managed funds. 

It’s important to remember that index funds can never outperform the market they are connected to. This means that if the FTSE 100 were to go up by 5% over one year, the FTSE 100 tracker would rise at just under 5% (after factoring in the annual fund charge). The same applies if the FTSE 100 were to go down by 5%. In this case, your investment would fall by just over 5%.

Index Funds Explained: How Do UK Index Funds Work?

The amount you put in a tracker fund is pooled along with other investors who put money on that particular index. 

Later on, the fund manager allocates the money to stocks, bonds or other financial instruments that make up the index it tracks. 

Index funds can track the performance of an index in two different ways:

• Full replication—This is when you buy in all the components of an index so the fund can mirror the performance of the index as closely as possible. For instance, the FTSE 100 index fund will buy shares of all the 100 companies the index tracks. However, this is not always viable or feasible in practice. 
• Partial replication—Some index funds will purchase a sample of the companies that are most representative of a particular index, instead of buying shares in all the organisations the index follows. 

How Do You Make Money From an Index Fund?

There are two ways a UK index fund can make money:

Net Asset Value (NAV)

NAV calculates the value of your index fund investment by taking all the assets you own and multiplying them by their current value. If the value of the shares of an index goes up, NAV goes up too and so does the value of your investment. 

Dividends 

If the index fund you’ve invested in contains dividend stocks, then you are entitled to a certain amount depending on how much you’ve invested in the index fund or the weighting the dividend-paying company has in that tracker fund. 

Things to Be Aware of Before Investing in Index Funds UK

These are the most important things to think about before investing in index funds. 

Index Fund Weighting

When an ETF provider weights their portfolio it means that the companies in the index with a higher market cap will take up a higher percentage of the index fund. This will affect where your money goes. For instance, if a company has a 4% weighting on a certain index and you invested £10,000 into the fund, then you are holding £400 worth of shares in that company. 

Tracking error

This is the best way to assess the performance of a passive investment fund. The tracking error will show you how much the fund’s performance deviates from the index it is tracking. 

Bear in mind that a 0% tracking error is next to impossible. As long as the tracking error is below the cost of the fund, your investment is doing well.

Your capital is at risk

Even the lowest-risk investment can put your money at risk. This is a very important aspect to consider before you put your capital in the stock market or any kind of investment. If you are not comfortable with the idea of losing it all, it might be better to pass on investing. 

What Index Funds to Invest In?

Investing in index funds is pretty easy, but to make a smart investment, you’ll need to do a bit of research. 

Keep these things in mind when you’re choosing a UK index fund:

Pick funds that reflect your investing strategy

If you are a risk-taker, consider investing in index funds that track small and medium-sized companies or emerging markets. If you are not comfortable with high-risk investments, then it’s safer to go for high-grade domestic and international companies like Coca-Cola, Apple or Amazon. 

Define your goals

Depending on what you hope to achieve and when, pick the index that suits you the most.  For example, if you have a long-term goal such as investing for retirement, you can choose a more aggressive investment like an equity index fund. However, for short-term investing, more conservative options like a broad market index fund that offers more stable value is a better choice.

Geography

You could choose to stick with UK companies only or branch out to international stock. Alternatively, you could invest in an ETF tracker fund that tracks UK and international companies.

Asset Type

There is a huge range of indices to track, including natural gas, oil and gold. Keep in mind that if you want to track or invest in property, you will have to go with an actively-managed fund as this asset cannot be tracked. 

Consult an Independent Financial Advisor 

An IFA will help you determine which investment plan is the best for you according to your long-term goals and the level of risk you are willing to take on, especially if you have limited investing experience.

Ongoing Costs

Index funds have expense ratios of around 0.1%, which is not a lot compared to other investment funds. However, this means that you will pay around £100 a year if you invest £10,000 in an index fund in the UK. 

Find an investing platform

Even though you can invest directly into some tracker funds, buying shares through an investment platform is a much easier choice. There is a wide range of investment apps that can help you get started with investing in index funds in the UK.

Stick to easy and simple

There are several available UK index funds you can invest in, but before you jump the gun and put your money in an index that has performed well in the last few years, you need to take some time and look for the simplest option. Start with a UK or global index fund and move on to specialised tracker funds once you’ve gained some experience. 

Think about tax

Once you start making money from index funds, you will need to think about paying tax on your returns. SIIPs and ISAs are tax-free savings accounts so you can use them as wrappers to protect your investment from tax.

Real Examples of Index Funds

Here is a short list of some of the best UK index funds available right now:

• iShares Core FTSE 100 UCITS ETF: This 100% passive fund is one the best to track the FTSE 100. 
• SPDR S&P 500 Index: This well-known index tracks 500 of the biggest companies in the US, such as Apple, Amazon and Microsoft and has a historical annual return of 10%.  
• FTSE SmallCap Index: This UK index fund provides exposure to smaller companies listed in the UK under the FTSE 250 index.

How to Buy Index Funds in the UK? 

This is a very straightforward procedure once you have decided which investment platform you will use and what index fund you will invest in.

1. Open an account with an investment app and deposit funds to get started
2. Choose the index fund in which you want to invest
3. Select the amount you wish to invest

Pros and Cons of Index Funds

If you still haven’t made up your mind about investing in a tracker fund, consider these pros and cons. They might help you reach a final decision.

Pros

• Lower fees 
• Low risk and steady growth. Since they don’t strive to beat the market, tracker funds often perform better than actively managed funds.
• Diversification of your portfolio. You can buy slices of a huge number of companies all at once rather than single stocks. 
• Index funds are more transparent allowing you to better assess the risks involved. 
• Tax efficiency. Index funds buy and sell stocks less frequently which reduces capital gain taxes.

Cons

• Some index funds can be involved in high-risk investments: The index is dominated by a certain type of sector, and if that goes down as it did in the banking crisis in 2008, your investment will also fall. 
• Index funds lack flexibility because they track a particular index and if a stock within that index becomes overvalued or undervalued, you don’t have the ability to act, nor does your fund manager.
• You can never beat the market the way a managed fund can, so although the performance remains steady, there are no big gains when you invest in index funds vs investing in stocks or other individual funds that can get you a much bigger profit.

What About Other Investment Funds?

There are other options to consider. 

Index Funds vs. Actively-Managed Funds

The main difference lies in fund allocation and management.

Active funds brokers and analysts will do research and pick the stock they believe is worth investing in. They can then sell or buy shares in order to beat the market. 

Managed funds tend to buy and sell investments more frequently than index funds. The former has a portfolio turnover (the amount of holdings sold and bought each year) of 50% compared to tracker funds that have a yearly portfolio turnover of just 20%. 

Actively managed funds are also more expensive. Index funds have expense ratios of 0.1%, whereas active funds fall in the 0.5% to 1.5% range.

Index Funds vs ETF

ETFs a type of index fund that is listed on the stock exchange. 

Although ETFs and index mutual funds have a lot of similarities—they are both passively managed, they both offer diversification to your portfolio and provide strong long term performance, they also have a few key differences.

• Index funds that can only be traded at the end of the trading day vs. an ETF which can be traded throughout the day.
• Index funds are single priced, so the buy and sell price is the same, while ETFs have different prices.
• ETFs are more transparent and liquid, so you can move money in and out with greater flexibility.
• ETFs are traded on the stock market so trading fees could stack up.

Bottom Line

Every investment carries risk, but if you prefer going with an investment approach that offers to minimise risk and provide a stable segment for your portfolio for the long-term, index funds for UK investors are an excellent idea.