Index Funds and ETFs Explained

A generation ago, investing meant paying a fund manager a hearty fee to pick shares on your behalf, in the hope they would beat the market. Then a simple, almost heretical idea took hold: rather than try to beat the market, why not simply own the whole of it, cheaply? That idea, the index fund, has since become one of the most powerful forces in personal finance.

Index funds and their exchange-traded cousins, ETFs, now sit at the core of millions of portfolios, from first-time investors to giant pension schemes. They are cheap, transparent and beautifully simple. This guide explains what they are, how they work, the difference between the two, and where their limits lie. If you are still finding your feet, our guide on how to start investing sets the scene.

What an index is

An index is simply a measured list of investments that stands in for a slice of the market. The FTSE 100 tracks the hundred largest companies on the London Stock Exchange; the S&P 500 follows five hundred big American firms; a global index such as the FTSE All-World or MSCI World spans thousands of companies across dozens of countries. When the news says “the market rose today”, it is usually quoting an index.

An index fund is a fund built to mirror one of these indices as closely as possible. Rather than employing an expensive team to pick winners, it simply buys and holds the constituents of the index in the right proportions. If the index contains three thousand companies, so in effect, does the fund. You are buying the market itself, not a bet on someone's stock-picking skill.

This approach is called passive investing, in contrast to the active investing of a traditional stock-picking manager. The distinction is worth understanding properly, and we explore it fully in our guide on getting started and across the wider investment management topic. The headline is that passive funds do not try to beat the market, they aim to be the market, at the lowest possible cost.

How index tracking works

When you put money into an index fund, it is pooled with that of thousands of other investors and used to buy the shares (or bonds) that make up the target index. As companies enter or leave the index, the fund quietly adjusts to keep pace. Because there is no highly paid manager making judgement calls, the running costs are extremely low, and those savings are passed on to you.

The measure of how faithfully a fund mirrors its index is called tracking error: the smaller it is, the better the fund is doing its one job. Good trackers keep this tiny. The result is an investment that does, almost by definition, whatever the market does: you will never beat the index, but you will never badly lag it either, and you capture the market's long-run return at rock-bottom cost.

There is a subtle mechanical point worth grasping. Most mainstream indices are weighted by size, so the biggest companies make up the largest slices of the fund. This has a self-correcting quality, as a company grows, it automatically takes a bigger place in your holding; as it shrinks, it fades, but it also means a tracker can become concentrated in a handful of giants when a few sectors dominate the market. It is one of the few genuine quirks of passive investing, and a reason to check what your chosen index actually contains rather than assuming perfect balance.

Index funds vs ETFs

Index funds and ETFs (exchange-traded funds) both track indices cheaply, and for a long-term investor they do much the same job. The difference lies mainly in the plumbing, how they are priced and traded.

For someone drip-feeding a fixed amount each month, an index fund is often the tidier choice, since it usually costs nothing to buy and handles fractional amounts neatly. For someone who wants to trade during the day, or who prefers the wider choice of markets ETFs sometimes offer, an ETF may suit better. Neither is superior in the abstract: the right pick depends on how you invest, not on which is objectively best.

Why cost matters so much

The single greatest advantage of trackers is cost, and cost matters far more than most investors appreciate, because charges compound against you exactly as returns compound for you. A percentage point of fees skimmed off every year, for thirty years, quietly consumes a startling share of your final pot.

Consider two funds delivering the same underlying return, one charging 0.1% a year and the other 0.9%. That 0.8% gap does not sound like much, but over decades of compounding it can swallow tens of thousands of pounds from a substantial pot. Because a tracker's low cost is guaranteed while a manager's outperformance is not, the arithmetic tilts heavily in the tracker's favour, which is the crux of the wider debate between active and passive investing.

The pros and cons

Trackers are powerful, but they are not magic, and it pays to understand the trade-offs before you commit.

The most important caveat is that a tracker offers no protection in a downturn: if the index halves, so does your fund. Diversification across many companies reduces the risk that any single one ruins you, but it does not shield you from a fall in the whole market. Investments can fall as well as rise, and this is information, not personal advice.

How to choose a tracker

With thousands of trackers available, a few practical checks narrow the field quickly.

• 1

  Check what it actually tracks

  A global index gives you the broadest diversification; a single-country or single-sector index is narrower and more concentrated. Know what you are buying.

• 2

  Compare the ongoing charge

  Among funds tracking the same index, the cheapest is usually the sensible choice, since they are all trying to do the same thing.

• 3

  Look at the tracking error

  A smaller tracking error means the fund follows its index more faithfully, its core job done well.

• 4

  Decide on accumulation or income

  Accumulation units reinvest dividends automatically for growth; income units pay them out. Choose to match your goal.

For most long-term investors, a single broad global tracker, accumulating, low-cost, following a worldwide index, is a remarkably complete building block all by itself. You do not need a shelf full of funds to be well diversified; one global tracker already owns a slice of thousands of companies across the developed and emerging world.

Building a portfolio with trackers

Trackers are the ideal raw material for a simple, robust portfolio. A common and sensible approach is a small handful of funds: a global equity tracker for growth, a bond tracker for ballast, and perhaps a slice of something more specialised if it suits your goals. Adjusting the balance between the equity and bond trackers is how you dial your risk up or down.

You can also hold trackers alongside investments that reflect your values, many index providers now offer ethical and sustainable versions that screen out certain industries. However you assemble them, wrapping your trackers in a tax-efficient ISA or pension keeps HMRC away from the returns, letting more of your money compound for you rather than for the taxman.

The beauty of a tracker-based portfolio is how little maintenance it demands once built. Because you are not relying on any manager's form, there is no need to monitor whether a star has lost their touch or a strategy has drifted. An annual glance to rebalance the split between your equity and bond trackers, a check that charges remain competitive, and otherwise a policy of masterly inactivity is usually all that is required. Much of the long-run advantage of passive investing comes not from cleverness but from this quiet discipline, low costs, broad diversification and the patience to leave a good thing alone.

Who they suit

Index funds and ETFs suit almost anyone who wants broad, low-cost exposure to the market without the expense, effort or uncertainty of stock-picking. They are especially well suited to long-term investors who value simplicity, and to anyone building a first portfolio who wants a solid, diversified core they can hold for decades.

They are less appealing to those who believe they, or a chosen manager, can consistently beat the market, and who are willing to pay and risk more in the attempt. If you would value help deciding how trackers fit into your wider plans, and how much risk to take, Vetted Wealth can match you free of charge with an independently vetted, FCA-regulated adviser. The choice, as ever, should rest on your own circumstances.

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