What is an index fund?

What is an index fund and how do they work?

An index fund is an investment vehicle that tracks an index. An index tracks how stock a stock market, or other assets, perform that meet certain criteria. For example, the S&P 500 includes the largest 500 companies in the US by market cap. The criteria will remain the same, even though the stocks within the 500 may change over time. Therefore, the index shows how this collection of stocks is performing.

Investors can’t invest in an index directly; rather, they need to buy a product based on an index, which could come in the form of an ETF or mutual fund. The fund tries to essentially replicate what the index is doing, so the index fund and index have roughly the same return, minus any fees charged by the index fund.

There are thousands of index funds tracking all sorts of indices. For example, there are clean energy and solar funds, and index funds related to sectors and industries, bonds, new technologies, IPOs, currencies, growth stocks, value stocks, and more.

Stock market or forex trading graph, Berkah, Getty Images

Advantages of an index fund?

Index funds are popular, so here are some of the benefits:

• Buying, or shorting, one index fund replicates hundreds of trades in individual companies. This makes it very efficient.

• Index funds are comparatively low cost and save investors commissions. For example, buying the SPDR S&P 500 Trust ETF provides exposure to 500 companies in one transaction. Buying 500 companies individually would take 500 trades.

• Index funds are transparent in that they track an index, and their method for doing so is published in the fund’s prospectus.

• Index funds provide diversification which helps to protect against volatility. Purchasing several index funds is equivalent to holding potentially thousands of assets from different industries, asset classes and parts of the world. That kind of diversification is hard to achieve without buying index funds.

• Performance is easily trackable and isn’t subjective. The index has set rules for determining its components and the fund replicates the index. The index fund performs based on how the index performs, as well as how the fund replicates the index.

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Disadvantages of an index fund

There are also some disadvantages of index funds. These can include:

• Index funds tend to return the average of their holdings, which means they will underperform when compared with very strong individual stocks and assets. Buying several top-performing stocks will usually outperform a diversified index fund, for example.

• Index funds can have tracking errors. This is when the fund’s performance doesn’t match the performance of the underlying index. The index is the benchmark, and the index fund may exceed or underperform the benchmark.

• Investors can’t pick and choose what is in their index fund. What is in the fund – and how it is managed – is outside of the investor’s control.

• There are costs to holding an index fund, such as a yearly management fee called the expense ratio. These fees vary significantly.

• It is an easy way to replicate the performance of the broader global stock market and benchmarks.

How do I choose the best index fund to invest in?

There are a lot of different types of index funds and choosing one can be overwhelming. Here are some tips to help break down the choice:

• Consider the cost of owning the index fund. Fees are discussed in more detail below but, generally, lower fees mean that it will cost you less to own the index fund.

• Look at how an index has performed. If a certain fund tends to outperform others that have a similar investment methodology over the long-term, then that information can help to narrow down the best fund to pick.

• Weigh the cost against the return. Sometimes, a higher fee is preferred by investors as it may mean that the returns are also higher.

• Consider the asset classes you want to own. Index funds are available on stocks, bonds/fixed income, currencies, treasuries, commodities, and real estate. Consider what you wish to own and the factors that move those different asset classes, then seek out those types of funds. The criteria in the previous points may help to filter it down.

• Think about your investment objectives with stock index funds. There are diversified, international, sector, industry, value, growth, and dividend funds, to name a few. Consider which of these has the most appeal to you. Also, consider the risk factor and what your risk tolerance is. Some funds move both up and down much more than others.

How do index funds deal with dividends?

For distributing ETFs and mutual funds, dividends are received by the index fund, then paid out to owners of the fund. Typically, this is done quarterly, but the payout frequency can vary by product. The index fund’s prospectus or webpage should show the yield investors have received from holding the fund.

The dividend yield is the number of yearly dividends divided by the price of the index fund. For example, if a fund has a dividend payout of £3 and the price of the index fund is currently £150, the yield is 2%. Yield will change any time the dividend payout changes or the index fund price changes.

A fund may accumulate dividends instead of distributing them. The fund manager can then use dividends payments to reinvest in the fund. In this case, the shareholder doesn’t receive the dividends, rather the dividends are kept inside the fund.

How are index funds taxed?

Tax laws vary by jurisdiction. For distributing ETFs and funds, investors will typically need to pay taxes on the dividends received unless they hold the fund within a tax-protected account, such as an ISA.

For non-distributing ETFs and funds, taxes don’t typically need to be paid up until you make £2,000 in dividends, which is the dividend tax free allowance amount, according to Barclays.

Example of investing in an index fund

Let’s assume an investor has funds available in their brokerage, ISA or spread betting account. They decide that they want to invest that money into a couple of index funds. They choose to buy ETFs since they can be bought and sold throughout the day with ease.

They do some research, potentially looking at what index fund’s past performance has been (discussed in the section below), or what indices may do well in the future. They choose to buy the iShares Core FTSE 100 ETF (ISF).

They then place a buy order for the index funds they choose. If available with their chosen broker, they can use a market order to buy at the current offer price, or they can use a limit order to try to buy it at a lower price. For example, if the offer price is $692.60, they could use a market order to purchase the ETF at that price right now. Or, after studying the chart, they may decide to buy on a pullback in price and will place an order of $685, for example.

There is no limit on how long the trade is held. It can be held short-term, for a matter of seconds or minutes, a few days to a few months, or it can be held over the long-term for many years as an investment.

List of best performing index funds

Below you will find the funds with the best performance in terms of share price increase over the past five years (as of early October 2021, source: CMC Markets). Only funds with an average daily trading volume of at least 100,000 trades are considered.

• First Trust NASDAQ Clean Edge Green Energy Index Fund (QCLN) - Increase of 326%

• Invesco Solar ETF (TAN)​ - Increase of 321%

• iShares Semiconductor ETF (SOXX) - Increase of 316%

• Amplify Online Retail ETF (IBUY)​ - Increase of 301%

• Global X Lithium & Battery Tech ETF (LIT)​ - Increase of 268%

• iShares U.S. Technology ETF (IYW) - Increase of 256%

• First Trust Cloud Computing ETF (SKYY) - Increase of 216%

• Invesco QQQ Trust (QQQ) - Increase of 214%

• Global X FinTech ETF (FINX)​ - Increase of 210%

• Renaissance IPO ETF (IPO)​ - Increase of 203%

Low-cost index funds

Here are the index funds with the lowest expense ratios. Only funds with at least 100,000 share daily average volume are included.

Cost isn’t the only thing to consider – you should also look at returns. Higher fees should garner larger returns. If a higher fee fund can’t beat a lower cost one, you may opt for the lower-cost one. For bigger returns, sometimes a higher fee is worth it.

What are some of the most diversified index funds on a global basis?

• The FTSE All-World ex-US ETF (VEU)​​ tracks developed and emerging markets worldwide, which is 90-95% of the global investable market. There is also an accumulating version, where dividends are not paid out but rather kept inside the fund.

• The Vanguard FTSE Developed Markets ETF (VEA)​​ provides exposure to developed markets around the world.

• The Vanguard FTSE Emerging Markets ETF (VWO)​​ tracks stocks from global emerging countries.

• While the iShares Frontier 100 ETF (FM)​​ doesn’t hold as many stocks as the others, it is invested in a wide range of frontier countries. Frontier countries – including Kuwait and Vietnam, for example – are less developed than emerging countries.

What’s the average return for an index fund?

Global stock markets will vary in performance, but the average returns in dominant benchmark indices across the US are as follows:

• The SPDR S&P 500 ETF (SPY)​, which tracks the largest companies by market cap, has returned on average 10.55% per year since its inception in 1993.

• The Invesco QQQ ETF (QQQ)​, which tracks US technology stocks, has returned on average 10.03% per year since its inception in 1999.

• The iShares Russell 2000 ETF (IWM)​, which tracks small-cap US stocks, has returned on average 9.19% per year since its inception in 2000.

• The iShares Core FTSE 100 ETF (ISF)​​, which tracks the 100 largest UK companies, has returned on average 4.01% per year since inception in 2000.

What fees are associated with index funds?

There is often a commission for purchasing an index fund or an ETF. Commissions vary depending on the product and broker.

In addition, there is an annual management fee. This can range from less than 0.1% to several percent per year. This fee is referred to as the expense ratio and includes all costs associated with managing the fund. It is deducted from the fund each year.

The situation is different when you trade index funds as CFDs with us. Unlike the classic ETF product, you trade ETF CFDs​ without overnight holding costs plus fixed commissions of $10 on US ETF CFDs, regardless of position size. Additionally, you can bet on falling ETF CFD prices, i.e. go short. Learn about general CFD trading costs such as the spread.

Compare the two trading options in our table below.

Try trading ETF CFDs for free and risk-free with CMC Markets!

What is the difference between ETF CFDs and ETFs?

* Before taxes and fees; Source: CMC Markets

Strategies to know about when investing in index funds

For buy-and-hold investors, the primary thing to be aware of when investing in index funds is portfolio management. Portfolio management includes how and when you rebalance​​ and how you diversify the portfolio​​.

Portfolio rebalancing is keeping the desired asset mix in the portfolio. For example, if you own five index ETFs and one does extremely well, over time, that index will compose more of the portfolio than it once did. Rebalancing is buying and selling the index funds to bring the portfolio into proper balance.

This also leads to diversification and deciding how many index funds will be in the portfolio and what weighting each will be given. A conservative approach may be to have the most capital in several diversified funds – domestic and international – with only a small amount in more speculative or higher volatility funds. Another investor may prefer more capital in more speculative funds.

Shorter-term traders can use index funds to capitalise on trends. If technology stocks are popular, for example, they could buy a technology index fund. Or, if the price of oil is rising, an oil or oil producer index fund may benefit.

Popular ETF strategies

• Cost averaging: Traders invest in ETFs at regular intervals to benefit from more favorable entry prices over a longer period of time.

• Asset allocation & diversification: ETFs allow traders to invest in a variety of products or different strategies, enabling them to diversify their risk in almost any market.

• Swing trading: If an investor can identify potential highs or lows in an ETF's price development, they can attempt to profit from the reversal through swing trading.

• Sector rotation: When some sectors reach their peak in terms of profitability, some investors often seek higher returns elsewhere by looking for the next undervalued opportunity.

• Hedging: Some ETFs have been designed with defensive asset or equity positions in mind, while others focus on returns during volatility spikes. Traders can even hedge their portfolio with a more broadly diversified investment in index ETFs.

• Short Selling: With CMC Markets ETF CFDs, you can take long or short positions to participate in both falling and rising markets. For example, if you believe a sector or area is doomed to fail, you can trade this opportunity with the desired flexibility.

• Seasonal Trends: Some traders like to take advantage of the potential rally in stocks or gold during Christmas or during the Indian wedding season or Diwali, when demand reaches its peak.

How many index funds should I own?

This is a personal choice depending on how much diversification is desired for the portfolio. An index fund holding 500 companies is diversified by most people’s standards. Yet, those are all US companies and large ones. Some people may wish to add index funds from other countries or an index that includes smaller companies.

Since index funds are a cost-effective way to gain exposure to a large basket of stocks with one transaction, you should weigh the diversification benefits versus the average return of each index fund.

Some index funds have higher average returns than others. Including more higher-returning funds will theoretically tend to increase the long-term return of the portfolio. Including more lower-return funds may pull down the average return.

What is the difference between an index fund's yield and total return?

A fund’s yield refers to the dividends received as a percentage of the price for holding the investment over a set period, usually one year.

Total return is the change in the value of the index fund itself over the holding period or over a set period.

For example, if an investor buys an index fund or ETF at a price of £100, and it tends to pay a £1 dividend each year, its yield is 1%. The current yield is the expected dividend amount divided by the current price of the asset.

But say, over the course of the year, the dividends are paid, and the index fund or ETF is now trading at £110. The capital gain increase is £10, and the fund also paid a dividend, which is also a return.

Factoring that in, the total return is £10 + £1 = £11 / £100 = 11%.

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