Index Funds

This article is intended to answer the question:

How do I invest in a way that my returns will track the overall UK, US, or global stock market?

or perhaps more specifically, a question like:

How do I invest in the FTSE 100?

The short answer is that the FTSE 100 is an example of an index, which tracks the largest UK companies. You can invest in it through an index fund. Let's unpack that.

What is an index?

An index is a calculated value that summarises the performance of some category of assets into a single number which can be tracked over time. For indexes which track stock markets, this is typically the total valuation of the companies in some section of the stock market. For example, the FTSE 100 is an index which tracks the value of the largest 100 companies listed on the London Stock Exchange.

Market indexes are normally calculated using capitalisation weighting, where the companies included in the index are selected based on their market valuation, and the larger the market valuation of a company, the more weight it is given in the index.

What is a capitalisation-weighted index?

In a capitalisation-weighted index, the index is calculated by summing the total market value of all of the companies. This means that if one company is worth £20 billion, and another is worth £10 billion, the former company will contribute twice as much to the index. A 10% increase in the price of the former company would increase the index by twice as much as a 10% rise in the latter company.

An index is also usually normalised, so that it starts at a nice value like 1,000 on the first day it is measured. This normalisation happens by recording the sum of the market values of the companies on the first day, and then dividing later measures by this amount.

FTSE 100
The growth of the FTSE 100 Index, since its opening value of 1,000 on 3rd Jan 1984. (Source)

What is an index fund?

An index fund (also commonly referred to as a 'tracker') is a wrapper which will hold shares in the various assets in an index, weighted by the same weighting as in the index, so that the value of the index fund should track the underlying index closely over time. If the index goes up by 3%, then so should the index fund.

For example, an index fund which tracks the FTSE 100 has £1 billion invested in it in total, then that £1 billion will be used by the fund manager to buy £1 billion worth of shares in the FTSE 100 companies, weighted by their market value, so that the fund would hold twice as much of a £20 billion company than a £10 billion company. As the valuations rise and fall, and as companies come in and out of the FTSE 100, the index fund will buy and sell shares to keep their allocation as close to the FTSE 100 weighting as possible.

Why use capitalisation weighting for an index?

By using a capitalisation-weighted index, the index is measuring how the market is choosing to allocate capital. If the market value of one company in the index is £20 billion (the total value of all of the company's shares adds up to £20 billion), and another company has a market value of £10 billion, then the shareholders are valuing the first company at twice as much as the second. If they weren't, then some people would sell shares in the company that they thought was overvalued, and buy shares in the other company that they thought was undervalued, until the prices shifted to match what people think. Of course some people might think this, while others think the opposite, so the market value only represents the average sentiment of the shareholders. There is no correct objective valuation, only the valuation that comes from the average of all the shareholder decisions. This is why we talk about market value rather than just value. By using a capitalisation-weighted index, the index tracks this market valuation.

Now we could define loads of different indexes based on completely different criteria. For example, rather than worrying about market capitalisation, we could form an index based upon the value of all companies whose names begin with an 'L'. It's unlikely that this would tell us anything particularly interesting about the market though!

Why the market average is the best you can do

When you invest in an index fund tracking a capitalisation-weighted index, you are delegating your investment decisions to the market. You will be investing in companies in the index in proportion to how much capital everyone else has invested in these companies. This may seem like blindly following the herd, and you might think that you can do better than this, but you almost certainly can't.

The reason you can't beat the market is that it's a zero-sum game - if you're going to do better than the average, someone else has to do worse than the average. So if you are going to do better than the market average over the long term, you need to make better decisions than at least 50% of the other people making active investment decisions. When the market contains institutional investors, hedge funds, people with PhDs, very fast computers, and significant amounts of money, it's unlikely that you're going to be in the upper half.

Instead of trying to beat the market average yourself, you might be tempted to invest in an actively managed fund, where the investors try to make strategic picks to beat the market. The managers of such funds certainly have more resources available to them than you, and some even have excellent histories of market beating returns. However, there's no way for you to tell if an actively managed fund is actually better than the market average, or if they've just been lucky in the past.

To illustrate this, consider the following thought experiment: If I pick 500 people and ask them to flip a coin 10 times in a row, I'd expect one or two of them to get 10 heads in row. If we pick one of those people, and look at their coin flipping record, then this person appears to be very talented at flipping a coin and getting heads. However, if I asked them to flip the coin again, they would have a 50/50 chance, just like everyone else. So in a world where there are many actively managed funds, some will have done better than the market average in the past. But how can we tell whether they were just lucky, or, on the contrary, if they will continue to beat the market? The unfortunate answer is you likely can't.

Structure of Index Funds

So far, we've covered the theoretical rudiments of the index fund concept, but in order to actually get your money invested, you'll need to know a little bit about what real index funds look like in practice. If any of the terms in this section are unfamiliar to you, you might want to start with Your First Steps in Investing.

In the UK there are two common legal structures for index funds:

  • Open Ended Investment Companies (OEICs). An OEIC is essentially a limited company which you can buy shares in. The company then uses the money from the sale of its shares to purchase the underlying assets in the index it is trying to match. OEICs are often referred to simply as 'funds'.
  • Exchange Traded Funds (ETFs). An ETF is like an OEIC, but it is publicly traded on an exchange. This means you are buying and selling shares in the ETFs from other investors, rather than the fund itself. New shares are created and dissolved as needed to match demand.

The legal structure of these funds doesn't matter too much to you as a personal investor, but there are some differences between OEICs and ETFs that you should be familiar with:

  • Liquidity. ETFs trade on a public exchange, so the price changes frequently, all day. You can buy and sell shares in an ETF quickly, at any point during the day. OEICs on the other hand are priced once per day, and after placing a buy or sell order, it will typically not execute until noon the next working day.
  • Cost. Brokers typically charge different amounts for trading shares on a public exchange, compared to buying units of an OEIC. It will vary from broker to broker, but brokers often charge significantly less for trading shares in an OEIC, compared to an ETF. On the other hand, there's often an extra ongoing 'custody fee' or 'platform charge' percentage levied upon OEIC holdings by the broker. How much this matters will depend on your broker, the size of your portfolio, and how frequently you plan on trading.
  • Ongoing charges. Both OEICs and ETFs will have ongoing management charges, which will be an annual percentage of your holdings. These are deducted automatically from your returns. There's no clear distinction between OEICs and ETFs here, but make sure you're aware of the ongoing charge in whichever fund you choose. For straightforward index funds tracking an index like the FTSE 100, expect an ongoing charge of less than 0.1% a year.

For more information on the differences between OEICs and ETFs, check out this write up from Monevator.

Company size, geography and other factors

Hopefully the previous sections have demystified the workings of indexes and index funds to some degree. However, you may still have questions about which index funds to invest in. That's worth a whole separate write up, but here is a brief overview of the landscape of some of the different types of index funds that are available:

Large cap, mid cap and small cap

Large cap companies are those with the largest capitalisations, and in the UK typically refers to the FTSE 100 companies. That is, the largest 100 companies in the UK. The smallest company in the FTSE 100 has a market capitalisation of around £4 billion. Some example index funds tracking large cap companies are:

Mid cap companies are those with smaller capitalisations, typically referring to the FTSE 250 companies, which are the 101st-350th companies in the UK by market capitalisation. The market capitalisation of these ranges between around £4 billion to £500 million. Some example index funds:

Small cap companies are those with smaller market capitalisations still, but it's a less well defined list than large or mid cap companies. An example index fund:

Geography

Index funds also provide a convenient way to invest in foreign markets, outside the UK. The funds are located in the UK, and priced in GBP, so they are very accessible to a UK investor, but can hold investments in European, US, or global markets.

The S&P 500 index is similar to the FTSE 100 index in the UK, but tracking the top 500 companies in the US. The Vanguard S&P 500 ETF is an index fund tracking the S&P 500.

Likewise, the EURO STOXX 50 index tracks the largest 50 companies in Europe, and can be invested in through index funds such as the iShares EURO STOXX 50 UCITS ETF.

There also exist indexes which aim to track the global market, such as the MSCI World index.

Other assets

As well as indexes which track company valuations, there are indexes which track bond valuations. For example the Vanguard UK Government Bond Index Fund aims to track the Bloomberg Barclays U.K. Government Float Adjusted Bond Index.

Index funds can also track other asset classes, like gold, property, and even alternative assets like Bitcoin.

Funds of funds

A single index typically represents a narrow cross section of the world, likely tracking only companies of a certain size, in a certain region, or a certain asset class. You may need to hold investments tracking multiple indexes in order to have a diversified portfolio across different assets types, company sizes and geographies. Rather than doing this manually, it is also possible to invest directly in a fund of funds. In this case, the fund holds a number of different underlying funds, tracking different indexes. This allows a single fund to have appropriate diversification.

Some examples of these funds of funds, particularly those aimed at passive investors are:

Hopefully this article has helped to explain what an index fund is, and why you might be interested in investing in index funds. The above examples are certainly not a full list of the available indexes and index funds, and you should do further research into which funds are most appropriate for your investment goals. We'll be following up this article with another article to help you work out which index funds are right for you. Subscribe to our email list to get updated when we publish it.

Good luck with your investment journey!

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