In recent years, index funds have gained popularity among investors in the UK. These are passive investment vehicles that track the performance of a market index, such as the FTSE 100 or the S&P 500. Index funds offer a simple and efficient solution for those who want to diversify their portfolio without high costs.
In this comprehensive guide for 2025, we will look at what index funds are, how they work, what advantages and disadvantages they offer, and who they are best suited for. We will also provide some practical tips on how to integrate index funds into a long-term investment strategy.
What are index funds?
An index fund is a mutual fund or ETF (Exchange-Traded Fund), which is a passively managed financial instrument that replicates the performance of a benchmark index. This means that the fund manager does not actively select securities, but simply buys the same assets in the index, in the same proportions.
To give a concrete example, a fund that tracks the FTSE 100 holds shares in the 100 leading companies listed in London. This approach significantly reduces management costs, as no active selection or in-depth analysis is required.
How do index funds work?
Before looking at when it is advisable to invest in index funds, it is important to understand how these financial instruments work. Specifically, when an investor buys shares in an index fund, the money is used to purchase all the components of the chosen index. The value of the fund therefore tends to closely track the performance of the index, net of management fees.
There are two main approaches to replicating an index. In the first, called physical replication, the fund directly purchases all the securities in the index, ensuring a direct and transparent match. In the second approach, known as synthetic replication, the fund uses derivatives to achieve a return similar to that of the index without physically holding all the securities. Generally, physically replicated index funds prevail in the UK, as they are considered clearer and more understandable for retail investors.
Why choose index funds?
There are many reasons for the growing popularity of index funds. First of all, index funds have low costs thanks to the absence of active management. In fact, with passive management, management fees are usually lower than those of traditional funds. In addition, it is possible to achieve broad diversification even with limited capital, accessing hundreds or thousands of securities through a single transaction. This makes investing simple and transparent, with an approach that allows you to clearly understand where your money is being invested.
In terms of performance, however, it has been observed that over the long term, many index funds manage to achieve results in line with or even superior to actively managed funds. This is due, in part, to lower costs and the efficient nature of the market.
Risks and limitations of index funds
Of course, index funds are not without risk. Their return is closely linked to the performance of the benchmark index: if the market falls, the fund will also suffer losses. Furthermore, there is no active attempt to mitigate such declines through dynamic management, as the fund strictly follows the composition of the index.
Another aspect to consider is the so-called tracking error, i.e. the difference between the fund’s performance and that of the index. Although the tracking error is generally low in index funds, it can still affect overall returns over time and this aspect must be carefully considered when selecting funds for your portfolio.
How to choose an index fund
Choosing an effective index fund requires attention to several factors. It is important to evaluate the index that the fund intends to replicate, for example, the FTSE 100 for the UK market, the MSCI World for investors with a global outlook, or other thematic indexes. Another key factor is the level of fees, often represented by the Total Expense Ratio (TER): the lower it is, the higher the net returns for the investor.
A good fund should also have a low tracking error, meaning that it should always replicate the index accurately. Other important indicators are the size and liquidity of the fund, as these characteristics affect the stability and ease with which you can enter or exit the investment.
Index funds and ETFs: what are the differences?
Although they share the philosophy of passive investing, index mutual funds and ETFs have some practical differences. ETFs are traded in real time on the stock market, just like stocks, while traditional mutual funds are valued and purchased only once a day, based on their net asset value.
This feature makes ETFs more flexible for those who want more control over the timing of their trades, although it requires more attention in day-to-day management. Mutual index funds, on the other hand, may be more suitable for those who prefer a “set and forget” approach.
A practical example: investing in the FTSE All-World Index
Let’s now consider a practical example, assuming an investor who wants to gain broad geographical and sector exposure. An ideal solution could be an index fund that tracks the FTSE All-World. This index includes thousands of globally listed companies, covering both developed and emerging markets.
This gives investors access to a wide range of stocks in different countries and sectors through a single instrument, resulting in a naturally balanced portfolio that can reduce specific risk.
Index funds and long-term strategy
Index funds are particularly effective as part of a long-term investment strategy. They are ideal, for example, for pension plans or for gradually accumulating capital for future goals. Thanks to the power of compound capitalization, even small regular contributions can translate into significant returns over time.
Adopting a “buy and hold” approach, combined with regular purchases over time (accumulation plans), allows you to benefit from the average purchase cost. This makes it possible to reduce the impact of market volatility and improve the stability of returns over time.
Investing in index funds: final thoughts
Index funds are a simple, inexpensive, and effective solution for building a diversified portfolio. Although they are not risk-free, index funds are a valuable tool for those who want to invest for the long term without any complications.
Moreover, the growing popularity of index funds in the United Kingdom confirms the confidence that many savers have in these passively managed financial instruments, which are a useful and attractive option for balanced long-term investing.
FAQ
An index fund is a type of mutual fund or exchange-traded fund (ETF) that tracks the performance of a benchmark market index, such as the S&P 500 or the FTSE 100.
The three largest index funds in the world are the Vanguard Total Stock Market Index Fund, the iShares Core S&P 500 ETF, and the Schwab Total Stock Market Index Fund, all of which offer diversified exposure to the US stock market.
Mutual funds offer a passive investment strategy by replicating the performance of a market index. This is achieved by investing the fund’s assets in the securities contained in the benchmark index, in the same proportions.
The main difference between ETFs and index funds is that ETFs are traded on the stock exchange throughout the day like stocks, while index funds are only bought or sold once a day, at the end of the day.
Sources
https://www.investopedia.com/ask/answers/033015/whats-difference-between-index-fund-and-etf.asp
https://www.hsbc.co.uk/investments/what-is-an-index-fund
https://www.hl.co.uk/funds/index-tracker-funds
https://www.investopedia.com/terms/i/indexfund.asp
https://www.hsbc.co.uk/investments/what-is-an-index-fund
*As with all investing, financial instruments involve inherent risks, including loss of capital, market fluctuations and liquidity risk. Past performance is no guarantee of future results. It is important to consider your risk tolerance and investment objectives before proceeding.
