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Investing

Index funds explained

Index Tracker funds have surged in popularity recently, with investors receiving, on average, better long-term results than with actively managed funds.

Published June 2020

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Important Note

Our website offers information about investing and saving, but not personal advice. If you're not sure which investments are right for you, please speak to a qualified financial adviser.

The value of investments, and the income from them, can go down as well as up, so you may get back less than you invest.

Picking Index Funds

Index Tracker funds have surged in popularity recently, with investors receiving, on average, better long-term results than with actively managed funds.

When investors buy an index fund, they get a diversified selection of many stocks in one package, without having to purchase each individually. As these funds simply hold all the investments in a given index — versus an actively managed fund that pays a professional to do the stock picking — fees are low.

In the UK, investors have three types of index fund to choose from. All aim to achieve the same thing, to track the performance of an index ­­as closely as possible, and for investors the fees will often be the deciding factor, as the smallest difference can be a massive hit to your long-term returns.

On most investment platforms in the UK you’ll find two of three index fund types in a section labelled as ‘Funds’. These are the ‘traditional index funds’ – Open-Ended Investment Companies (OEICs) and Unit Trusts. They’re both open-ended funds, which means when you invest, the fund manager creates new shares in OEICs (because it’s a company) and units in unit trusts and then cancels them when you sell. The value of these shares and units directly reflects the value of the underlying investments held in the fund.

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In addition to the traditional funds, there is also a third option - exchange traded funds ‘ETFs’. Often ETFs are listed under the ‘Shares' section of the investment platforms (it seems ‘Shares’ really means ‘traded on an exchange’ and so ETFs, although funds, appear here). ETFs are also open-ended, like the traditional funds, but ETF shares are traded on a stock market, as such they are traded through a stockbroker as opposed to with the fund manager directly.

Hargreaves Lansdown sections

Funds (blue underline) = Traditional Funds (OEICs/Unit Trusts), Shares (red underline) = ETFs

Funds have various fees that are taken out of the fund before any returns are passed to investors. All three index fund types have a management fee, set by the fund provider. All also pay transactions costs; these are the fees brokers charge when the fund rebalances to match changes in the underlying index - the more an index fund changes, as a result of either the index changing or investors inflows/outflows, the more transactions there will be and the higher the transaction costs. ETFs and some Unit Trusts will also have a Bid-Offer Spread, this means the price that you buy and sell units of the fund at are slightly different, (if you bought the fund and sold it immediately, you would pay the bid-offer spread) – OEICs and some Unit Trust don’t charge this separately, and instead bake the cost into the other fees.

Often investment platforms charge one fee for buying and holding traditional funds, and one for shares (includes ETFs), so it is important that investors review not only the fees charged by different fund providers but also the platform fees.

In our view, investors don't have to worry too much about the type of index fund they are buying, but its important that the fees they're paying, to both the investment platform and the fund provider, are competitive. Fortunately, we have a page that calculates fees charged for by some of the major index funds as well as for each of the major ISA investment platforms.