Investing in index funds

What are index funds?

Index funds are passive funds that mirror the composition and performance of a financial market index. Indices can be benchmarks, such as the top companies in a country or any selection of companies, industries or geographies in a specific category. An index fund can mirror, for example, the S&P 500 or various emerging markets companies. Index funds can not only benchmark stocks, but also bonds, currencies or commodities.

Types of index funds

Index funds encompass index mutual funds and exchange-traded funds (ETFs). There are several differences to these types of index funds.

Index mutual funds usually are not geared towards quick trading because they have different share classes, sale charge arrangements and holding period requirements.

ETFs can quickly be traded, bearing in mind factors such as liquidity of the market. ETFs also don't have purchase minimums, which can be the case with index mutual funds, making barriers to entry lower.

What is an index?

An index tracks a basket of stocks, which can range from a selection of names in the double digits to those in the triple digits. A popular example is the Standard and Poor's 500 (the S&P 500), which tracks the stock performance of the 500 biggest companies listed on stock exchanges in the United States.

Then there is the Nasdaq Composite Index, an index tracking nearly all the names listed on the Nasdaq for those primarily interested in technology. Companies include NVIDIA and Nike among many others.

In addition, if you're looking for an emerging markets and frontier markets index, you could look at the MSCI Emerging + Frontier Markets (EFM) Index. This index tracks companies in countries classified as 'emerging' or 'frontier', representing 'emerging' countries that are seen as in the process of becoming a developed economy, or in the case of 'frontier', seen as less advanced economies in the developing world.

Indices are often well-monitored by market participants and media, as these benchmarks give an idea of how an entire industry or a country is performing.

Indices can be created by fund managers and by companies specialising in indices, such as the research, data and technology company MSCI.

How do index funds work?

An index fund tracks a specific index and invests in the companies that it mimics. Instead of beating the market, it aims to perform in a similar way as the market that it tracks.

A manager pools investors' money and uses it to invest in a portfolio of holdings that replicates an index. Investors can view the holdings of each index fund and look at the weightings to understand to what degree they have exposure to which company.

The weightings can be determined by price or by market cap. For the former, higher-priced assets have a larger ratio than lower-priced assets. For the latter, it all depends on the market cap of the company. The fund manager will adjust the share of assets to match the index, looking to ensure that the index fund's performance is similar to that of the index.

How risky are index funds?

Investing in these products is not without risk, since their holdings usually have a correlation to market movements. For beginners, investing in index funds could be a strategy to diversify their portfolios.

While investing in index funds is typically seen as a less risky investment approach, some index funds are more volatile than others. Index funds offer exposure to a wide selection of holdings. The most popular ones often represent the largest companies by market cap in a specific region or industry, but there are also different index funds. In short, large, mid and small cap indices all exist.

Index funds tend to seek market-average returns, while actively managed funds tend to look to outperform the market. Since index funds are passive funds, that also means that they are less costly than actively managed funds. The fees of index funds are incorporated in the price of the funds.

What happens to index funds when the market crashes?

The index fund could drop if the market that it tracks crashes. For example, if there is a global market crash, that fear may spillover to stocks in all parts of the world, potentially affecting an index fund investment in Germany, or a technology ETF in Japan.

However, if the index fund tracks a market that is either stable during or benefits from an economic crash, then the fund may be (largely) unaffected. For example, commodities such as gold could potentially do well in the case of an economic crisis and with that, an index fund tracking these commodities.

Index funds vs mutual funds

While index funds are passively managed, mutual funds are actively managed, which typically comes with steeper fees. Index funds are therefore a lower-cost option for investors looking to track indices.

As mutual funds typically try to beat the market with active management, there are debates on whether returns are higher with active versus passive investing. Researching specific funds may give an indication of how well each fund is performing.

How to invest in index funds

If you're considering investing in index funds, here are some tips you can consider:

1. Educate yourself: Learn about the different types of index funds available and their respective risks and potentials.
2. Research companies: Analyse each index according to its holdings, weightings and other important factors such as exposure to economic or political risks.
3. Diversify your portfolio: Spread your investments across multiple index funds to potentially reduce risk.

Some index ETFs we offer on our platform

Note: Some ETFs may (temporarily) not be available on our platform for your country due to regulatory reasons.

Pros & cons of investing in index funds

As with all investments, it is important to weigh the advantages and disadvantages. Here are some about index funds you can consider:

Pros of investing in index funds

• Lower fees than actively managed funds: The fees for these passive funds tend to be lower than those of actively managed funds. They represent a relatively low-cost approach to getting exposure to a basket of stocks that can have hundreds of holdings.
• Diversification: Investing in index funds can provide diversification benefits, as these funds operate across various industries, markets and geographies.
• Easy way to get exposure to many companies: Indices track many companies at once, with large ones such as the S&P500 tracking 500 companies. Rather than having to buy 500 individual stocks, you could buy an ETF based on the S&P 500.

Cons of investing in index funds

• Inability to pick and choose holdings: Since you're tracking an index when investing in index funds, there could be holdings included that you aren't especially focused on. It's more of a one-size-fits-all solution.
• Results are based on weighting: With an index fund, your investment in a stock that jumps will be reflected by its weighting in the index. This means that if one stock outperforms, your index fund won't rise as rapidly as that one stock does, as it represents just one of many names included in the basket of stocks.
• While typically seen as a less risky approach, they are not without risk: In the case of a market crash, it's possible that your index fund will similarly experience a drop. Riskier index funds can also be more volatile.