Index tracker funds have grown in popularity as a low-cost way of gaining exposure to a broad range of shares.
Black Rock reports that global investment in exchange-traded funds (a proxy for index funds) hit its highest level on record in 2022. However, this was at the expense of its mutual fund counterparts, which continued to suffer net outflows last year.
Index funds aim to track or replicate the performance of an index, such as the FTSE 100 or the S&P 500 in the US. In addition to tracking different indices, tracker funds also vary by fees charged and how closely they replicate the performance of their index.
In the FAQs below, we explain how index funds work, what they offer investors and what to look for when choosing your fund.
We also asked Laith Khalaf, head of investment analysis at investing platform AJ Bell, to suggest five index funds for investors. His selections are listed below (in alphabetical order), along with the methodology behind his choices.
Performance data is sourced from Trustnet on a total return basis. Dividend yields are based on expected distributions over the next year divided by the current value of the fund (unless otherwise specified) and sourced from Fidelity.
Remember: investment is speculative and your capital is at risk. You may not get back some or all of the money you invest.
ââFidelity Index World Fund
Fund size: £4.3 billion (January 2023)
Fund type: Open-ended investment company (OEIC)
Target index: MSCI World Index
Annual fund charge: 0.12%
Five year return: 50%
Key points
- MSCI World Index is a benchmark for over 1,600 large and medium-sized companies across 23 developed markets.
- As with most stock indices, this index is weighted by the market capitalisation, or value, of the companies.
- The three largest sectors are financial services, information technology and healthcare, accounting for around half of the index.
- Due to the high valuations of technology companies, nearly 70% of the fund is invested in US equities. The fund’s top four holdings, Apple, Microsoft, Alphabet and Amazon, account for around a tenth of total investments.
- However, the fund has delivered a negative return of 5% in the last year, principally due to the fall in the price of US technology stocks.
Who should invest?
The Fidelity Index World Fund offers a low-cost option for tracking global stock markets, along with a small dividend yield of 1.8%. However, given the current volatility of US technology stocks, this may be a better option for investors looking to invest over the longer-term.
iShares Core FTSE 100 ETF
Fund size: £11 billion (January 2023)
Fund type: Exchange-traded fund (ETF)
Target index: FTSE 100
Annual fund charge: 0.07%
Five year return: 20%
Key points
- The FTSE 100 index comprises the 100 largest companies listed on the London Stock Exchange by market capitalisation, or value. It includes a significant proportion of well-established companies operating in the financial services, energy and mining sectors.
- The FTSE 100 has lagged its counterparts, such as the S&P 500 and Nasdaq in the US over the last five years due to its bias towards low, rather than high, growth stocks.
- However, the index has managed to deliver a modest return of 3% over the last year, despite the general downturn in stock markets. It has benefited from the shift in investor appetite from growth to defensive stocks, which tend to hold up better in an economic downturn.
- The FTSE 100 companies also typically pay higher dividends than US growth companies.
Who should invest?
This fund may appeal to investors looking for an income, with an annual dividend yield of 3.8%. It provides a ready-made portfolio of large-cap UK shares with the lowest annual fee of the funds in our list.
The fund has delivered a 8% return in the last year, with the share prices of UK blue-chips benefitting from investors looking for more cautious investments in the current stock market downturn.
iShares Core MSCI EM (Emerging Markets) IMI ETF
Fund size: £13.3 billion (January 2023)
Fund type: Exchange-traded fund (ETF)
Target index: MSCI Emerging Markets Investable Market Index (IMI)
Annual fund charge: 0.18%
Five year return: 7%
Key points
- The term ‘emerging markets’ refers to developing economies, although it includes a diverse range of countries at different stages of development.
- Around 60% of the fund is invested in the industrial powerhouses of China, Taiwan and India, together with resource-rich countries such as Brazil, Saudi Arabia and South Africa.
- Emerging markets may offer the potential for high growth, with booming working-age populations and expanding middle classes. This should deliver strong economic growth, and an increase in stock market value, over time.
- However, investing in emerging markets is also higher risk due to their volatility, with possible issues including political unrest, lack of regulation and economic deficiencies.
- Emerging markets are often highly dependent on exports to developed economies. As a result, a fall in demand (due to a recession) can prompt a downward spiral as investors transfer their money to safer options.
Who should invest?
This fund may appeal to adventurous investors looking to diversify their portfolio and gain exposure to global emerging markets. However, investors should be prepared for a bumpy ride along the way.
iShares Physical Gold ETC
Fund size: £11 billion (January 2023)
Fund type: Exchange-traded commodity (ETC)
Target index: LBMA Gold Price
Annual fund charge: 0.12%
Five year return: 56%
Key points
- Exchange-traded products (ETPs) are a popular, low-cost way of investing in commodities.
- This fund is backed by physical gold, held in a secure vault, and its price tracks the spot price of gold.
- This differs from the majority of commodity ETPs that avoid the cost and complexity of storage by investing in futures contracts, rather than the asset itself.
- Gold is often seen as a safe haven in times of economic and geopolitical volatility. As its price is a function of demand and supply, the value of gold tends to rise when stock markets are falling.
- However, the price of gold can be volatile and this fund does not provide an income or dividend for investors.
Who should invest?
This fund provides a low-cost way of diversifying a portfolio across different asset classes. However, as a general rule of thumb, gold should comprise no more than 5-10% of a portfolio due to its volatility.
iShares MSCI World SRI (Socially Responsible Investment) ETF
Fund size: £5.3 billion (January 2023)
Fund type: Exchange-traded fund (ETF)
Target index: MSCI World SRI Select Reduced Fossil Fuel Index
Annual fund charge: 0.20%
Five year return: 60%
Key points
- There has been a rise in popularity of ethical investing over the last decade, with significant investment in environmental, social and governance (ESG) funds.
- This ETF tracks an index composed of around 380 ESG-screened companies in developed markets that meet climate change criteria.
- The index excludes companies with material interests in certain industries, including oil, gas and coal mining, tobacco, gambling and weapons.
- Over 60% of the fund is invested in the US, with the largest holdings being Microsoft, Tesla, Nvidia and Home Depot.
Who should invest?
Investors looking for a low-cost global fund which meets ethical investing standards. However, due to its exposure to US stock markets, the fund has delivered a negative year-to-date return of 17%.
Methodology
AJ Bell’s head of investment analysis, Laith Khalaf, highlights two main criteria in selecting index tracker funds: “We consider whether a fund in question is effectively tracking its benchmark index and also look at the annual fund charge which plays such a crucial part in tracker fund returns.”
Why invest in shares?
There are several reasons to invest in the stock market, with the main reason likely to be the potential to make higher returns than cash-based products. With inflation hitting a 40 year high of 11% last year, share-based investments also offer the potential to make ‘real’, or above-inflation, returns.
According to trader provider IG, the FTSE 100 has delivered an average total return of 8.4% (from 1984 to 2019). By comparison, the average interest rate on instant access savings accounts is currently around 2.50%.
How can you invest in shares?
If you are looking to invest in shares, it’s worth considering the various options. You could buy shares in an individual company, however this is a higher-risk approach if the shares underperform, or the company encounters financial difficulties.
You could spread the risk of a single company underperforming by buying shares in a number of companies. However, share trading fees can add up and it requires time to monitor the performance of multiple companies.
Funds, such as index trackers, provide a low-cost, ready-made portfolio of shares or other assets. Index funds are passively-managed as they aim to replicate an index rather than picking shares.
By comparison, actively-managed funds are a higher cost option as the choice of investments is made by a fund manager. As a result, annual fees are typically 0.5% to 1.5% compared to less than 0.2% for passive funds. However, managers of active funds can take steps to protect against losses if stock markets fall.
Frequently Asked Questions (FAQs)
What is an index tracker fund?
Index tracker funds are also known as index, tracker or passive funds. They are a type of collective investment product where investors’ money is aggregated and managed by a professional investment management firm.
Index trackers aim to replicate the performance of a stock market index, such as the Nasdaq 100 in the US, or a commodities index, such as the Dow Jones US Oil and Gas Index.
Tracker funds will replicate the performance of a particular index and rise and fall in line with the index. This differs from actively-managed funds where the fund manager aims to ‘beat’ an index through stock-picking.
There is a wide choice of index funds, including those:
- Tracking a broad stock market index, such as the FTSE 100, Nasdaq Composite or MSCI World Index
- Tracking a particular sector, such as technology, property or healthcare
- Tracking different assets, such as commodities, property or bonds
- Focusing on particular investing styles, such as ESG or cautious funds
Why invest in an index fund?
Investors paying higher fees for actively-managed funds will naturally expect these funds to outperform their lower-cost passive counterparts. However, research shows that this is not often the case.
According to Morningstar, only 26% of active funds have beaten the average of their passive rivals over the last decade (to December 2021). However, this varied by category, with at least 40% of small cap, European and property funds outperforming their passive peers.
It’s also worth looking at the degree of outperformance. In the UK All Companies sector, the top-performing active fund, Slater Recovery, has delivered a 5-year total return of 48%. The top-performing passive equivalent was the iShares 100 UK Equity ETF which achieved a considerably lower 5-year return of 21%.
Overall, investing in an index fund is a low-cost way of gaining exposure to stock markets, without having to try to pick the top-performing active funds.
How do index trackers work?
Index funds aim to mirror an index in one of two ways:
- Full replication: the fund buys all of the components of an index. For example, a FTSE 100 fund would buy shares in all 100 companies in proportion to their relative market capitalisation. This is most common in indices with a smaller number of shares.
- Partial replication: the fund buys a representative sample of companies from an index. This allows the fund to track the performance of an index without the cost of owning every stock. This is more common in indices with a large number of holdings, or more illiquid shares.
What is tracking error and tracking difference?
The tracking error provides a way of analysing the performance of an index fund, by measuring how far the fund’s returns deviate from the index. Tracking error is measured as a percentage, with a tracking error of 0% indicating perfect replication.
The tracking difference shows the absolute difference between the returns of the fund compared to the index over a specified period.
Investors typically look for a positive, or zero, tracking difference, along with a low tracking error. However, tracking errors vary by index, with the less liquid index funds (such as commodities and emerging markets) having higher tracking errors than mainstream indices (such as the FTSE 100).
How much do index funds cost?
In terms of annual management fees, index funds tend to be cheaper than actively-managed funds as replicating an index requires fewer resources than stock-picking.
According to the Investment Company Institute, the average fee for index funds is 0.06%, compared to 0.47% for actively-managed funds.
Fees for our “best” list of index funds vary from 0.07% to 0.20%, whereas typical fees for actively-managed funds range from 0.5% to 1.5%.
How do I buy an index fund?
You can buy index funds using an online investment platform, such as Hargreaves Lansdown, AJ Bell or interactive investor. Alternatively, you can buy them directly from the fund provider, or via a financial adviser.
You can hold index funds in a general investment account. Alternatively, they can also be held in an Individual Savings Account (ISA), Self Invested Personal Pension or Junior ISA. These accounts provide a ‘tax efficient wrapper’ as any profits and income are free from capital gains and income tax respectively.
What’s the difference between an index fund and an ETF?
Both index funds and ETFs are passive investments that track an index, however, the two products differ slightly:
ETFs are traded on the stock exchange, like shares, and their price fluctuates throughout the day. You buy or sell ETFs using ‘live’ prices, and they have a ‘buy-sell’ spread (investors will pay a higher price to buy ETFs and receive a lower price to sell them).
Index funds are a type of open-ended investment company (OEIC) which are priced according to the value of all the assets held in the fund. They are forward-priced and traded once a day, meaning that investors don’t know the purchase or sale price until after the trade has been executed. They are also usually ‘single priced’ meaning that the buy and sell price is the same.
What fees will you pay for buying index funds?
In addition to the annual management fee mentioned above, the following fees may also be charged when buying and selling index funds:
- Share trading fee: this is a flat fee charged when you buy or sell ETFs, and typically varies from £5 to £10. Many platforms do not charge a trading fee for buying or selling funds (and some platforms do not charge for share trading either).
- Platform fee: this is an annual fee charged for holding your investments. Some platforms charge a percentage of the value of your investments, generally around 0.25% to 0.45% of your portfolio, while others charge a flat fee. Some platforms do not charge a fee for holding shares in ETFs, rather than funds, and others cap the platform fee on shares.
If you’re considering investing in index funds, it’s worth reviewing the different fee structures of the trading platforms to find the best value option for your circumstances.
What’s an exchange-traded commodity?
Exchange-traded commodities are similar to ETFs, but track the performance of an underlying commodity index, such as the price of precious metals, oil and gas and agricultural products.
What’s the risk of losing money in an index fund?
Investing in the stock market carries the risk that your investments will fall in value. However, a diversified portfolio of investments, such as an index fund, reduces this risk.
The risk of an index fund varies according to the index itself - investing in commodities or emerging markets index funds would be considered higher risk than investing in developed markets or bonds.
It’s often argued that active funds perform better in a market downturn, as they’re able to hold some of their portfolio in cash and switch to more defensive investments. However, this is not always the case in practice.
