How to Invest in Index Funds

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Contents:

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The easiest way to invest in index funds in the UK is to buy them online from an investment platform or fund supermarket, such as Interactive Investor, AJ Bell, or Vanguard.

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Follow the steps below to invest in index funds in the UK:

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1. Open an account with an investment platform, such as Interactive Investor or AJ Bell. An investment platform or fund supermarket allows you to buy, sell, and manage index funds, active funds, ETFs, and other kinds of investments, including stocks and shares, bonds, and commodities. Not all investment platforms in the UK allow retail investors to buy funds, but all fund supermarkets do.
   
   
2. ‍Verify your details and fund your account using a debit card or via bank transfer. Depending on the platform you choose, you might need to submit your national insurance number or upload a copy of a valid ID card, such as your passport or driving licence, to create your account. Once your account is created, you need to add funds to it. You can only buy index funds in the local currency, GBP, so you need not worry about exchange rates or the associated FX fees.

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3. Choose a tax wrapper, such as an ISA or SIPP. A tax wrapper reduces the taxes you pay on your savings and investments. Examples of tax wrappers in the UK are individual savings accounts (ISAs) and pensions. If you do not want to use a tax wrapper, perhaps because you have already used up your ISA allowance for the tax year, you can choose to invest in a general investment account (GIA). A GIA also comes with some tax benefits.

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4. Research index funds. Before investing in any stock market product, it is crucial to carry out some research. To help you kick off your research, here is a list of our top 10 UK index funds.
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5. Create an investment strategy, such as the Bogleheads’ three-fund portfolio. To become a successful investor, you must create an investment strategy that works for you. Most people create their own version of Bogleheads’ three-fund portfolio (see below), while others simply invest in one index fund that tracks the whole world. When creating an index fund strategy, you should also consider your current age, risk tolerance, and how long you plan to hold your investments.

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6. Choose and invest in your preferred index funds using the platform’s web or mobile app. When you are ready to invest, you need to choose your index funds or ETFs. Enter the name of the index fund or the ticker symbol of the ETF into the search bar of your preferred investment platform or fund supermarket’s web or mobile app. Once you locate the fund, you may buy as many units as you want. You will also need to decide whether you want to buy index funds or ETFs of the income class (receive dividends) or accumulation class (automatically reinvest dividends). More on income vs accumulation below.

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7. Invest small amounts regularly to take advantage of pound-cost averaging. It is important to keep on investing small amounts into your portfolio regularly. Investing small amounts regularly is known as “drip-feeding” into your investment pot, and it can sometimes be better than investing a huge lump sum once. This investment strategy is called dollar-cost averaging or pound-cost averaging. It is a technique that minimises the risk of market volatility by spreading out your investments over time, leading to buying more units when prices are low and fewer when prices are high.

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8. Monitor your portfolio and rebalance when necessary. Keeping an eye on your investments and making adjustments when necessary is an important part of maintaining a healthy portfolio. Once you have established a steady investment routine, it is crucial to stay involved and adapt your strategy when needed. Remember, investing isn’t a set-it-and-forget-it kind of endeavour. It’s a dynamic process that requires consistent attention and maintenance.

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We’ve compiled a list of the best platforms for index funds in the UK. These are the best index fund brokers, investment apps, websites, and fund supermarkets for buying, selling, and holding UK index tracker funds, ETFs, and other investment products.

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Please remember that when you invest, your capital is at risk. ISA, pension, and tax rules also apply. The platforms listed below are authorised and regulated by the UK’s financial watchdog, the Financial Conduct Authority (FCA).

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Here are the best platforms for index funds in the UK:

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Imagine you’re at a supermarket, and instead of picking out individual items, you could just pick up a basket that already has a little bit of everything you need. In the world of investing, an index fund is kind of like that pre-packed basket.

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An index fund is a type of investment that includes a little bit of many different companies’ stocks. These companies are usually part of a big list called an “index”. Think of this index as a shopping list and the companies on it as the items. A well-known index is the FTSE 100, which includes 100 of the biggest companies in the UK. So, if you invest in an index fund that tracks the FTSE 100, you are essentially buying a small piece of each of those 100 companies.

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To elaborate, index funds are not only limited to the UK. For example, there’s a famous index in the US called the S&P 500. It is like the FTSE 100 but contains 500 of the largest US companies. If you put your money in an index fund that follows the S&P 500, you’re buying a tiny share of each of those 500 companies.

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And here’s the fun part - index funds are not just about stocks! They can be made up of other kinds of “ingredients” or assets, too. You’ve got index funds filled with bonds, which are basically loans you give to companies or governments in exchange for interest. There are also index funds composed of real estate, where your money goes into a mix of different property-related investments. Some even have a mix of everything - a true financial smorgasbord!

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So, think about it. If you pick a “basket” or index fund filled with a variety of these assets, you’re not just betting on one company or one type of investment. Instead, you’re spreading your chances across hundreds of different companies or bonds or properties. It is like getting a taste of the whole investment buffet without having to buy everything separately.

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Think back to our supermarket analogy. Suppose you had to pick each item for your basket individually. You’d walk up and down every aisle, read all the labels, compare prices, and maybe even check the quality of products. That’s a lot of work and can take hours! But what if you don’t have all that time? Or what if you’re not sure what makes a good loaf of bread or which apples are the best? That’s where our pre-packed basket (our index fund) comes in handy.

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The first major reason to invest in index funds is convenience. You don’t need to spend countless hours researching and choosing individual companies to invest in. You’re getting a bit of everything in one neat package, saving you a lot of time and effort.

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Another reason is diversification. Think of it like a diet. If you only eat one type of food, you might miss out on the nutrients other foods offer. It is the same with investments. If you only invest in one company or one type of asset, you might miss out on the growth and profits that others may offer. Plus, if that one company doesn’t do well, you could lose a lot. An index fund, with its mix of different investments, can help protect you from this. It’s a bit like having a balanced diet for your finances!

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Cost is another factor. Investing in an index fund is typically cheaper than buying lots of individual investments. It is like the difference between buying a pre-packed basket of groceries versus buying each item individually. With the latter, you might end up paying more for packaging, labels, and the like. It’s the same with investing. Index funds usually have lower fees than if you were to buy and manage all those investments separately.

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And lastly, it is about simplicity. Imagine trying to keep track of hundreds of different investments – checking each one’s performance, dealing with paperwork for each, and so on. It’s like trying to cook a hundred different dishes at once! With an index fund, you’re effectively getting one ‘dish’ that’s made up of hundreds of different ‘ingredients’. It is much easier to manage and keep track of.

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So, by investing in index funds, you’re not just saving time and effort; you’re also spreading your risk, keeping costs low, and making life simpler! It is like getting the best parts of the investment world all in one basket.

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Now that we’ve got a handle on index funds, let’s introduce a new player to our supermarket scene: the ETF or Exchange-Traded Fund. Imagine this as another type of pre-packed basket, only this one has some nifty features that our regular index fund basket doesn’t.

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Firstly, while index funds and ETFs are similar – both are baskets of investments that follow an index – there are differences in how you can buy and sell them. Imagine you’re shopping in a supermarket where you can only check out once a day, at the end of the day, no matter when you arrive or finish shopping. That’s how index funds work. You can only buy or sell shares in the fund at the end of the trading day when the price is set.

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Now, what if you could check out any time you want, with prices changing throughout the day based on what people are willing to pay? That’s more like an ETF. ETFs are traded on an exchange, just like individual stocks, which means their price can fluctuate throughout the day, and you can buy or sell them whenever the market is open.

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Secondly, consider the minimum investment required. Going back to our supermarket, let’s say the pre-packed basket (index fund) requires you to spend a certain minimum amount, but the special basket (ETF) lets you spend as little or as much as you want. This feature of ETFs can be appealing, particularly for those who are just dipping their toes into the investment waters and might not have a lot of capital to start with.

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But remember, just like when you’re shopping, it’s not just about convenience and price. It’s also about what’s inside the basket and whether it suits your needs. Both index funds and ETFs offer a diversified selection of investments. Whether one is better than the other for you depends on your individual circumstances - how much you want to invest, how often you want to be able to buy or sell, and what exactly you’re looking for in your investment ‘diet’.

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And just like when you’re choosing a supermarket or a diet, it’s always a good idea to do your homework before deciding on an index fund or an ETF. After all, you’re not just shopping for groceries here – you’re shopping for your future!

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Our journey through the world of index fund investing is taking another turn. Let’s imagine we’re at our favourite bakery. You see two types of cakes: one you can only savour in the bakery (income), and another you can take home to enjoy later (accumulation). In the world of index funds and ETFs, you have to choose between an ‘income’ and an ‘accumulation’ version of a fund.

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When we talk about ‘income’ funds, think about it like this: you’re investing in a group of companies, and these companies are profitable (hooray!). So, they decide to share these profits with their investors - that’s you - in the form of dividends. Now, if you’re invested in an ‘income’ fund, these dividends are handed over to you, usually as cash deposited into your investment account. Just like how you can enjoy that cake right in the bakery, income funds allow you to reap and use the benefits of your investments in the here and now.

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On the other hand, we have ‘accumulation’ funds. Let’s go back to our bakery. This time, you decide to take your cake home for later. This mirrors what happens in an accumulation fund: instead of handing you the dividends, the fund automatically reinvests these profits back into the fund, buying more of the ‘cake’ for later. You won’t see a cash deposit in your account, but the value of your investment will increase because you now own a larger slice of the fund. Essentially, you’re allowing your investment to grow and compound over time, hopefully leading to a bigger cake for you to enjoy in the future.

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So, whether you should choose an income or an accumulation fund will depend on your personal circumstances and what you want from your investments. Do you need the cash now, perhaps for a regular income? Then, the income fund might be the better choice. But if you’re in it for the long haul and want to benefit from the magic of compounding, you might want to consider the accumulation fund. And remember, there’s no one-size-fits-all answer. Your choice of cake depends on your own unique taste.

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There are two ways to build an index fund portfolio. The first is by creating your own version of Bogleheads’ three-fund portfolio, and the second is by simply investing in an index fund that tracks the whole world.

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1. Three-Fund Portfolio

A three-fund portfolio is a simple passive investing strategy that involves investing in three types of index funds or ETFs with a long-term horizon of at least 20 years.

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The three funds are typically:

1. A domestic stock “total market” index fund,
2. An international stock “total market” index fund, and 
3. A bond “total market” index fund.

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Here is an example of how this could look in practice:

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Fund 1 could be an index fund or ETF that tracks the local UK market, i.e. a fund that tracks the FTSE UK All Share Index.

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Fund 2 could be an index fund or ETF that tracks the global (developed world + emerging market) or US “total” stock markets. For example, a fund tracking the S&P 500 Index.

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Fund 3 could be an index fund or ETF that tracks the performance of UK government bond indices such as the Bloomberg UK Government Inflation-Linked Float Adjusted Bond Index. 

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Here is a list of some of the best index funds and ETFs in the UK.

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Once you’ve chosen your index funds or ETFs, you have to adjust the allocation of each fund based on your risk tolerance. For instance, a risk-averse investor might hold a portfolio heavily tilted toward bonds. Similarly, someone bullish on the US or an emerging market like China might hold a portfolio that disproportionately favours a US or global index fund. Finally, if you would like a great deal of “home stocks” in your portfolio, you might allocate the largest portion of your portfolio to the UK index fund.

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Other factors to consider when building an index fund portfolio include your current age and how long you plan to hold the index funds. You should also consider the previous performance of each index fund while keeping in mind that past performance is not a reliable indicator of future results.

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The Bogleheads’ three-fund portfolio was originally created by Bogleheads in America.

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2. Global or “Whole World” Index Fund Portfolio

If you are the kind of investor who would prefer a single index fund to set and forget rather than invest in multiple funds, a global index tracker might be a good choice for you.

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Global index tracker funds track the performance of companies worldwide, ranging from developed countries to emerging markets.

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When you buy an index fund that tracks a global market, you gain exposure to companies in the US, the UK, other developed countries, and even emerging markets like Latin American countries. Global index trackers are an excellent choice for people who want a highly diversified portfolio without limiting themselves to the domestic and US markets.

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We’ve put together a list of some of the best global index tracker funds and ETFs, available via the best online brokers for UK index funds.

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The advantages of investing in index funds are low cost, broad diversification, transparency, ease of accessibility, and convenience.

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The disadvantages of investing in index funds are lack of flexibility, inability to beat the market (in theory), tracking errors, lack of downside protection, and concentration risk.

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Pros of Investing in Index Funds

Here are some advantages of investing in index funds:

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1. Low Cost: The fees on index funds are quite low compared to active funds because of the “low-touch” investment strategy used by index fund managers.

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2. Broad Diversification: Since index funds hold investments from several publicly listed companies, they are well diversified and can have better long-term returns than an actively managed fund once fees are considered.

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3. Transparency: For those after maximum transparency, another positive of index funds is that you know exactly what your money is being invested into at all times.

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4. Ease of Accessibility: Index funds are relatively easy to access, and you can buy the most popular ones on any online fund supermarket in the UK.

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5. Convenience: Unlike investing in individual stocks and shares, when you invest in an index fund, you do not have to worry about constantly researching companies, timing the market or rebalancing your portfolio.

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Cons of Investing in Index Funds

Here are some disadvantages of investing in index funds:

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1. Lack of Flexibility: When you invest in index funds, you have no control over the exact components of the fund or the weightings attached to each component.

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2. Inability to Beat the Market (in theory): By definition, an index fund cannot outperform the market.

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3. Tracking Error: Tracking error is a measure of how accurately an index fund is able to track its index. Tracking errors could lead to positive or negative results, so a fund with a high negative tracking error could perform well below the index.
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4. Lack of Downside Protection: In times of high volatility, such as during the peak of the Coronavirus pandemic in 2020, there is no cap on losses.
   
   
5. ‍Concentration Risk: Most index funds track indices based on market capitalisation, economic sectors, location or a combination of all three.
   
   Additionally, all holdings in most index funds do not have equal weightings. For example, a UK 100 index fund that tracks the performance of the 100 largest companies on the London Stock Exchange will have about 20% of its holdings in financial services.
   
   Similarly, an S&P 500 index fund tracking the 500 largest companies listed on American exchanges will have about 25% of its holdings made up of companies in the technology sector. This kind of composition exposes your portfolio to concentration risk.

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We’ve outlined some typical index fund fees below. You can always find the full details of an index fund’s charges in its Key Investor Information Document (KIID).

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Pro Tip: Fixed fees tend to work out cheaper for people investing high amounts, whereas percentage-based fees tend to be less expensive for those with little to invest.

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Here is a breakdown of the fees you pay when investing in index funds in the UK:

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1. Annual Fund Management Fee: The fund management fee, also known as an ongoing charges figure (OCF) or total expense ratio (TER), is the fee paid directly to the index fund manager responsible for managing your fund. When you invest in funds, you typically select a few funds to invest in. If you selected three different funds, for example, you would have to pay a fund management fee for each fund.
   
   
2. Annual Platform Fee: The platform fee, also known as a custody fee, is charged by the investment provider or fund supermarket providing a platform for you to invest. It is usually expressed as a percentage of the total value of your portfolio or a fixed fee.
   
   
3. ‍Market Spread: The market spread, also known as transaction cost, is the difference between the buy and sell prices of an asset like an ETF.
   
   
4. Trading Fee: The trading fee, also known as a dealing fee, is the fee for buying and selling funds, shares or other types of investments. Most platforms do not charge a dealing fee for buying and selling index funds, but the ones that do usually charge an amount ranging from £0.01 to £25.‍‍
   
   
5. Transfer-Out Fee: The transfer-out fee, also known as an exit fee, is the fee you pay for moving your investments from one fund provider to another. Not all platforms charge an exit fee, but those that do typically charge per fund or holding.
   
   
6. ‍‍Advice Fee: A financial advice fee is only paid if you opt-in for financial advice.

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To buy index funds in the UK, you’ll need to:

1. Open an account with an investment platform, such as Interactive Investor or AJ Bell.
2. Verify your details and fund your account using a debit card or via bank transfer.
3. Choose a tax wrapper, such as an ISA or SIPP.
4. Research index funds.
5. Create an investment strategy, such as the Bogleheads’ three-fund portfolio.
6. Buy your preferred index funds using the platform’s web or mobile app.
7. Invest small amounts regularly to take advantage of pound-cost averaging.
8. Monitor your portfolio and rebalance when necessary.

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Here are the top 10 index funds to invest in, along with their respective ongoing charges figure (OCF):

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1. UBS S&P 500 Index Fund - 0.09%
2. Legal & General US Index Trust - 0.05%
3. Vanguard FTSE 100 Index Unit Trust - 0.06%
4. Vanguard FTSE UK All Share Index Unit Trust - 0.06%
5. Vanguard FTSE Global All Cap Index Fund - 0.23%
6. Fidelity Index World Fund P - 0.12%
7. Fidelity Index Europe ex UK - 0.10%
8. Vanguard Global Bond Index Fund (Hedged) - 0.18%
9. iShares Emerging Markets Equity Index Fund (UK) - 0.20%
10. iShares Environment & Low Carbon Tilt Real Estate Index Fund (UK) - 0.17%

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To view the comprehensive list, see Best Index Funds in the UK.

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You can buy index funds in the UK from the following investment platforms:

1. Interactive Investor - One free trade per month; 3,000+ funds
2. AJ Bell - Low cost; Lots of investment options; 2,000+ funds
3. Hargreaves Lansdown - Lots of investment options; 3,000+ funds
4. Vanguard - Low cost; 70+ funds

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The best way to invest in index funds in the UK is to open an investment account with a reliable fund supermarket, such as AJ Bell, Interactive Investor, or Vanguard. These platforms offer a range of index funds to choose from. After funding your account, you can select and purchase the index funds that fit your investment strategy. Additionally, consider investing through a tax-efficient wrapper like a Stocks and Shares ISA or a personal pension. For instance, if you invest in an index fund within an ISA, you won’t pay tax on any profit you make on your investments up to £20,000 per tax year.

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Investing in the S&P 500 index fund can be a smart choice for those looking for exposure to the American stock market. This index fund tracks the performance of 500 of the largest US companies, offering a diversified portfolio. It is like owning tiny pieces of prominent firms like Apple, Amazon, and Microsoft all at once. While no investment is without risk, historically, the S&P 500 has provided stable long-term returns.

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Absolutely! Even though the S&P 500 index is based on American companies, as a UK investor, you can easily buy an S&P 500 index fund through many investment platforms or fund supermarkets. It is a great way to diversify your portfolio with companies from the world’s largest economy.

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The cheapest S&P 500 index fund in the UK is the UBS S&P 500 Index Fund, which has an Ongoing Charges Figure (OCF) or Total Expense Ratio (TER) of just 0.09%. This low fee means more of your money is invested in the fund, potentially leading to higher net returns.

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To invest in the FTSE 100 index fund in the UK, you need to open an investment account with a reputable fund supermarket such as AJ Bell or Interactive Investor, deposit funds, and then search for a FTSE 100 index fund. The FTSE 100 tracks the 100 largest companies listed on the London Stock Exchange. Think of giants like BP, GlaxoSmithKline, and Unilever. Remember to consider your risk tolerance and investment goals before investing.

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Yes, earnings from index funds in the UK are subject to tax. However, using tax-efficient wrappers like ISAs or pensions can help reduce your tax liability. For instance, investing in an index fund within a pension plan will allow your investment to grow tax-free until you retire and start drawing a pension.

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Yes, many UK index funds do pay dividends. These are portions of the company’s profits passed on to shareholders. Imagine you’re invested in an index fund that includes a successful company like Tesco. When Tesco makes a profit and decides to distribute dividends, you’ll receive your share. Depending on the fund, these dividends may be automatically reinvested back into the fund (an accumulation fund) or paid out to you as cash (an income fund).

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Credits

1. Bogleheads
2. GOV.UK