Finance > Investing in the Stock Market
What Are Index Funds?
Index funds are diverse, cheap and simple. They were pioneered by Jack Bogle, founder of Vanguard, in 1975. His idea was that instead of picking individual stocks and hoping that they perform well, just buy the whole lot. Or, in Jack’s words…
‘Don’t look for the needle in the haystack. Just buy the haystack!’.
In This Article
What Is an Index?
Think of an index as a bucket filled with investments that represent a part of the stock market. The bucket has an overall value, which changes depending on the performance of its contents. Investors typically use an index to measure their personal performance against the market.
An index can track the market, or a sector of it, by grouping companies of interest and monitoring their performance. The impact of each individual company within the index will depend on the weighting it has been allocated. Weightings are based on market capitalisation, share price, or split evenly.
Example:
The FTSE 100 (Financial Times Stock Exchange 100) is an example of an index within the UK. The index consists of the largest 100 companies on the London Stock Exchange, based on market capitalisation.
The FTSE 100 index will move up and down based on the performance of the 100 companies within it. The respective impact each company has on the index will be weighted based on market capitalisation, e.g. the largest company’s share price increasing 10% will have more of an impact on the index than the smallest company increasing 10%.
What Is an Index Fund?
An index fund aims to track the performance of an index (the bucket). So, for example, a FTSE 100 Index Tracker will track the FTSE 100 Index as closely as possible. It doesn’t try to beat it, simply mirror it. Investors can then purchase units in the index fund and their investment will mimic the performance of the companies held within it. Easier than individually buying shares in all the companies, right?
How Does an Index Fund Work?
Index funds will buy a representative sample of the shares within the index it wishes to track. When changes occur within the index, the fund will update its holdings accordingly. Having said this, exactly mimicking the index is extremely difficult, so tracking errors are likely to occur, albeit they are usually extremely small.
Why Are Index Funds So Popular?
Index funds are diverse, cheap and simple. They were pioneered by Jack Bogle, founder of Vanguard, in 1975. His idea was that instead of picking individual stocks and hoping that they perform well, just buy the whole lot. Or, in Jack’s words…
‘Don’t look for the needle in the haystack. Just buy the haystack!’.
Index funds are now widely available at an extremely low cost, making them a great option for new or passive investors to mimic a section of the market or a market as a whole.
Types of Index Fund
There are many different index funds that track all aspects of the market. Types of index funds can vary based on the below criteria:
- Company size
Small, Mid, Large Cap
- Location
UK, US, Global etc.
- Business Type
Tech, Industrial etc.
- Currencies, Bonds, Treasuries
In our example of the FTSE 100, this is based on the criteria of company size and location. It is based on large capitalisation companies listed on the London Stock Exchange.
Index Fund Names Explained
For a first time investor, a fund name can be quite confusing. The example below is a HSBC index fund for the FTSE 100. The meaning behind each section of the fund name is explained below.
HSBC FTSE 100 INDEX CLASS C – ACCUMULATION (GBP)
- HSBC
The first section will usually highlight who manages the fund. In this case, it is HSBC.
Note: There is more than one index fund per index; multiple firms will be tracking the same thing. The main difference will be the size of their tracking errors and the fees associated with the fund.
- FTSE 100 Index
The second section highlights the index that we are looking to track. In this case, it would be the FTSE 100 index.
- Class C
The class is the fund manager’s way of differentiating between different types of the same fund. For example, HSBC may have a Class B fund, which also tracks the FTSE 100 index however, the charges might differ slightly, or there may be minimum purchase requirements. Funds have different classes to target different types of investors. There is also no consistency between the class of funds across the board. For example, Class A in this fund may hold no similarities to Class A of another fund.
- Accumulation
Another thing to watch out for is ‘inc’ or ‘acc’ – standing for ‘income’ or ‘accumulation’. ‘Accumulation’ will automatically reinvest any income that arises from the fund, whereas ‘income’ will pay the money out to you as cash. Accumulation will benefit from compounding as you are putting your growth back to work straight away.
- GBP
Finally, the currency will be displayed within the fund name. In this case, GBP stands for Great British Pounds.
Share This Article
Related Articles
Index Funds vs Managed Funds
This article gives initial insights into both types of funds and some factors to consider when choosing between the two.
Understanding the Stock Market
This article is your introduction to the stock market, stock exchange and shares.
3 Steps to Start Investing
Getting started with investing is often the hardest part. This article breaks it down into three simple steps.