Why Invest in Index Funds?

What is an Index Fund?

An index or tracker fund is similar to a mutual fund (which may hold a basket of stocks e.g. 20 or 30). Instead of using a basket of stocks picked by a fund manager, an index fund holds the same stocks as you’d find in a market index. For example, if you invested in a fund that tracks the FTSE All-Share index, you fund would buy a part of more than 1000 companies traded on the London Stock Exchange.

What are the Advantages?

Low Cost
It’s a low cost investment vehicle.As the fund is passively managed you only pay for the cost of running it. As this is done by a computer the fees are very low. Whereas you’d expect to pay around 1% upwards for a fund manager (a human) to pick shares, you’re looking at paying between 0.1% and 0.5% (at the higher end) for an index fund every year.

Instant Diversification
With an index fund, you’re instantly exposed to a wide range of companies and industries. If one of the companies you invest in collapses, the impact on your portfolio will be minimal because your other holdings are likely to still be performing well.

Little or No Management
Once you invest in an index fund, there’s no management required until you decide to sell. As the fund is designed to track the index, the asset allocation will change with the index. You don’t need to manually execute anything except buying or selling the fund. You can even automate the buying process by buying more of an index fund every month using a direct debit instruction.

What are the Disadvantages?

Too Diversified
Some say that as a fund that tries to match the market it will provide ‘average’ returns. You’re unlikely to get the same growth that you could achieve in an actively-managed mutual fund.

You Still Need to Use a Strategy
Although index funds provide you with diversification, it’s not a substitute for not looking at other investments for your portfolio. It’s rarely enough just to own one stock index fund to give you enough exposure and growth potential.

How can I invest in an index fund?

In the UK, there are a number of platforms that provide you with an option to invest in an index fund. The Telegraph monitors the costs of each platform here. Once you’ve decided which provider to use, it’s important to stay on top of their charges. They will often write to you if their fees structure changes, but set a reminder every six months to check whether the platform is still competitive. I started investing using Alliance Trust Savings back in November 2010. Up until this month (Jan 2014), I had remained a loyal customer because of their rock bottom fees. From February 2014, I’ll be moving my investments to Charles Stanley Direct as they’re most competitive for me.

Final Note

As with any new investment vehicle, it’s important that you do your own research and fully understand what you’re investing in. Do not put money in any investment if you cannot afford to lose all of it. Likewise, no investment should be invested in and not monitored. I’m not suggesting checking it every day, but be sure to build in time throughout the year to check that it’s still the right investment for you and whether you need to rebalance your portfolio by buying or selling your funds.

All information provided at Life-Life Balance is for informational purposes only. MM is not a qualified financial advisor. Before making any decisions on your finances you should seek advice from a qualified advisor.

*Image courtesy of jannoon028 at Free Digital Photos.