Index Funds UK Explained: How to Invest For Beginners 2022 – Updated September 2022
Index funds and ETFs provide an opportunity to grow your wealth in the UK without worry.
It's a great way to start investing as a beginner in a diversified way without picking stocks.
In addition, it allows your money to be invested in a low-cost way on autopilot, giving you the market's return each year.
Recommended for beginners: Super Simple Investing course
Index Funds and ETFs: A Beginner's Guide
Index funds and ETFs are similar but have important differences.
They are both low-cost trackers with the goal of helping your money to be invested in a diversified way.
Before explaining these differences, let's take a step back and actually understand what an index is.
What Is An Index?
An index is a list, which is similar to a grocery shopping list.
However, rather than groceries, an index is a list of companies in the stock market that you can invest in.
Examples of such lists include the S&P 500, FTSE 100, FTSE 250, etc.
The S&P 500 is one of the most prestigious indexes because it is a list of the top 500 companies in the US equities market.
It's also a prestigious list because of the reputation of the company that maintains the S&P500 list i.e. S&P Dow Jones Indices.
That list is made of some of the largest tech companies in the world, hence, it has performed well historically.
In the same way as the S&P500, the FTSE100 is made up of the 100 largest companies in the UK equities market.
That list is reputable because of the companies on the list and their performance but partly because it's maintained by the FTSE Group.
What Is An Index Fund UK?
An index fund is a passive fund (a basket of companies) that tracks the performance of an index (a list of companies).
When you invest your money in an index fund, you invest it in a fund that then invests your money across the various companies on an index.
For example, if you invest £1,000 in the FTSE 100, that £1,000 is spread across the 100 companies on the index weighted by their market capitalisations.
By tracking the index, the index fund aims to deliver the same performance as the index itself.
Here is a look at the FTSE 100 Index performance over the last 5 years:
If you invest your money in an S&P500 Index Fund, then the goal of that fund is to get a return similar to the S&P500 index itself.
e.g. If the S&P500 index returns 9% in a year, then you'd expect the index fund tracking the index to return around 9% if the fund tracks it closely.
Here is a look at the S&P 500 Index performance over the last 5 years:
Note that you can have both equity and bond index funds.
Index Funds vs ETFs: What Are The Differences?
Index funds and ETFs are both trackers but there are differences:
ETFs are a hybrid between a stock and a fund and so get traded like a stock daily, with the price changing many times daily.
Whereas, an index fund's price only changes once a day after all the buys and sells are collected and processed.
Index funds and ETFs also attract different fees. With ETFs, you get charged a small commission each time you buy and sell.
But with an index fund, your charge is based on the value of your assets and your fee is charged as a percentage of your assets.
In general, ETFs are more cost-effective if you're investing larger amounts compared to index funds, which are more cost-effective on smaller amounts.
What Are Examples of Index Funds?
An example of an index fund that you can invest in from the UK includes:
‘FTSE Global All Cap Index Fund' provided by Vanguard.
Notice that for an ongoing cost of 0.23% per annum, this fund invests your money across 7,188 stocks globally.
Aside from Vanguard, another reputable provider of index funds is iShares in the UK.
Things To Know Before Investing In Index Funds and ETFs
It's important to know that although index funds are low-risk investments, they're still risky.
Your investments can go down as well as up.
It's also important to know that not all index funds are equal.
Some are good at tracking the index accurately whilst some are not.
Focus on investing in low cost globally diversified index funds and ETFs.
Read the Key Investor Information Document (KIID) of the index fund before investing.
This details the past performance, risks, cost and general information about the fund.
We cover more below on how to invest in index funds.
Recommended for beginners: Super Simple Investing course
What Are The Pros and Cons of Investing In Index Funds UK?
Here are the pros and cons of investing in index funds in the UK
Pros of Index Funds:
- Index funds are low cost and typically cost 0.5% per annum or lower.
- They outperform most actively managed funds.
- You get diversification as your money is invested in lots of different companies.
- They offer you a way to invest globally whilst living in a different country.
Cons of Index Funds:
- They can fall in value just like stocks.
- Index funds cannot outperform the index as they simply mimic them.
- The index fund can achieve lower returns than the index driven by the fees of the index fund. This is called the tracking error.
- Index funds differ in quality and can lead to significantly different levels of performance as a result.
What Is The Best Index Fund In The UK?
Some of the best index funds and ETFs accessible from the UK depend on various factors including performance.
Examples to research further include:
1. Vanguard S&P 500 UCITS ETF (VUSA) – OCF of 0.07%, fund size of £26 billion.
2. iShares Core FTSE 100 ETF – OCF of 0.07%, fund size of £10.6 billion.
3. Vanguard FTSE All-World UCITS ETF – OCF of 0.22%, fund size of £7.3 billion.
4. Vanguard FTSE 250 UCTIS ETF – OCF of 0.10%, fund size of £1.6 billion.
5: PensionBee's Fossil-Free Plan, if you want ethical investing that excludes tobacco and fossil fuels.
Note: This is not financial advice. Please do your research based on your risk appetite and goals.
The Best Low-Cost Index Funds To Buy Now
As the UK continues to face a challenging time economically, research by the FT has shows that there is an exodus of capital from UK-focused funds.
There is an increasing lack of faith in British stocks driven by the declining state of the economy, not helped by rising inflation and a weakening pound.
However, it is worth noting that the decline in funds being invested in UK stocks is not always tied to the UK economy, especially for multi-nationals.
With the above background information, I think it makes sense to keep your money invested globally.
Here are additional passive index funds to consider buying now:
1: Vanguard FTSE Developed World ex-UK Equity Index Fund – OCF of 0.14%
2: Vanguard LifeStrategy 80% Equity Index Fund – OCF of 0.22%
3: Fidelity Index World – OCF of 0.12%. This tracks the MSCI World Index.
4: Vanguard FTSE All-World UCITS ETF – OCF of 0.22%
5: Vanguard FTSE Global All Cap Index Fund – OCF of 0.23%
How to Invest in Index Funds UK
Let's say you've chosen an investment platform. How exactly do you decide what funds you're going to invest in?
Here is a step-by-step guide on how to choose index funds to invest in so you can achieve your goals.
Note that you can invest in index funds in these accounts:
Here are the things to consider:
1. Be Clear On Your Investment Goals
Step one is to be clear on your investment goals.
Let's say for example, that you are a 35-year-old, who is aiming to retire in 30 years from now with an investment portfolio of £750,000.
It's very clear from that what your investment goals are and how much you are aiming to achieve.
Therefore, choosing an investment fund is super important because you'd need to choose the right index funds that generate the right returns for you over time.
You're much more likely to achieve that goal in that 30-year period if you did so.
2. Decide On Income vs Growth
Next is to decide on income or growth.
I mentioned earlier the 35-year-old, who is likely to be focusing on the growth of their portfolio rather than their portfolio paying them an income.
However, you can have both if your portfolio does pay you out an income.
You ideally want to reinvest that income into your portfolio so that compounding can work for you in the long term.
So for that, you might want to focus on index funds that are accumulation rather than income or distribution.
Accumulation is where your income is reinvested automatically into your funds so that compounding can work in your favour.
Recommended: How To Choose An Investment Platform
3. Choose An Investment Strategy
Here you want to decide whether you want funds that are active in nature or passive in nature.
Active funds are ones where an investment manager is picking stocks or funds and making investment decisions on your behalf.
Whereas passive funds are our trackers by nature. So here we're talking specifically about index funds or ETFs.
Trackers are usually a lot cheaper than actively managed funds.
You can also have ready-made portfolios based on your levels of risk or interest.
4. Decide On Your Risk Appetite
Some funds show risk levels as either low risk, mid risk or higher risk, whereas some other funds show them as levels ranging from levels one to six.
So for example, levels one or two, indicate that a particular fund is made up predominantly of bonds and it's low risk.
If it's at level three or four, it indicates that it's a mid risk and that particular fund would be made up of a mix of equities and bonds.
And if the level of risk is around five or six, this indicates that this is a much higher risk fund that you're investing your money into.
That particular fund will be made up of predominantly equities.
So the asset mix asset allocation will be 100% equities.
Now the reason all this matters is that a higher risk fund usually leads to a higher reward or higher return over time.
And this matters when it comes to achieving your goals.
So choosing a fund that really matches your risk appetite is very important when you're choosing funds.
5. Check Fund Size and Age
Next is to choose fund size and age.
Here you want a fund that is of a decent size, ideally at least £100 million in terms of size.
For age, we'd say the longer the better because it gives you the opportunity to review their track record over time.
Look out for at least five to ten years of performance data.
Bear in mind that past performance is not an indicator of future performance.
If you are looking for a particular fund, or you're wondering where you find information such as the age or the size of the fund, you can find these quite easily in the fund fact sheet.
Some investment platforms also provide you with a filtering system where you're able to pick and choose funds that cover the various criteria that we are sharing with you in today's post.
6. Decide On What Region To Invest In
It's very important when you invest your money for your money to be well-diversified.
I'm talking about being diversified across different asset classes, but equally across different regions as well.
Regions you can invest your money into include:
- Asia Pacific,
- Emerging markets,
- USA, etc.
It's very important when you invest your money not to have local bias, but also think outside of where you currently live.
Think about the specific market you want to invest your money into.
I live in the UK and prefer to have my family's money invested globally.
And so you have that preference when you invest your money using passive trackers, for example.
You can also have funds that you invest into the exclude different areas.
So for example, you could have a fund that focuses on the Developed World but excludes an area like the UK, if you already have too much UK exposure.
7. Take a Look At Fees
The fees for investing in a fund, also known as the Ongoing Charge Figure (OCF) are usually expressed in a form of a percentage.
You'll usually get charged annually for running the fund you invest in.
Some funds actually charge you daily, but you might see the percentage expressed as an annual charge.
Investing cost money as you're paying for a service. However, what you choose to pay for that service matters and can affect the returns you generate.
The higher your fees, the less money you have working for you in the future.
So ideally you want to focus on a fund with lower fees, something around 0.something is good. e.g. 0.5% or lower.
But choosing the funds with the lowest fees should not be the only focus.
You should instead look at this from a long-term perspective and consider other factors such as the quality of service that you're getting from your platform provider.
Recommended: Investment Fees Explained
8. Review Past Performance
Past performance is good to look at because it gives you a real indication of the track record for that particular fund.
For example, has that fund delivered a good return year on year, or has it paid out a dividend on a consistent basis?
It's worth noting though, that as much as you look at the past, past performance is not a reliable indicator for future performance.
In terms of where to find information on past performance, look for this in the Fund Fact Sheet.
Alternatively, you can take a look at the Key Investor Information Documents (KIID) if you're a UK investor.
9. Check the Minimum Amount You Can Invest
Various funds have various minimum amounts that you need to meet in order to invest in them.
For example, some require a £500 minimum, whereas others require £100 a minimum for you to invest per month.
You also have platforms, which have lower minimums.
Simply check that you're happy with the minimum amount required to invest in that fund.
10. Think About Tax
The final step is to think about tax.
Make sure that you consider carefully what accounts you are investing your money in for your index funds and why.
There is a tax implication to investing money in the stock market, particularly when you come to sell your funds.
So you want to make sure that you're using the right accounts and that those accounts, whether they be your:
Make sure that those accounts can actually hold those funds having considered what the tax implications are of investing in those funds.
Conclusion on Index Funds UK
In conclusion, choosing what index funds to invest in is important because it will dictate how quickly you achieve your financial goals.
Most people who invest in funds tend to automate them and just forget about them and invest month after month.
It's very important that you follow the various steps that I have shared with you, in helping you choose the right index funds.
Aim for a maximum of around two to three index funds or ETFs when it comes to investing your money to create a simple global portfolio.
Make sure you watch out for any overlaps between these funds so you don't have funds invested in the same regions more than you want to.
In all this, enjoy investing in index funds as a UK investor and remember that it's all about having time in the market.
Feel free to check our beginner's investing course if you want to learn more via short actionable videos.
Frequently Asked Question About Index Funds UK
Here are frequently asked questions about investing in index funds UK:
1. Can you get index funds in the UK?
Yes, you can get index funds in the UK.
Simply check with your investment platform provider to see what index funds and ETFs they have on offer.
Index fund providers in the UK include Vanguard, iShares, etc.
2. What is the average return on index funds UK?
The FTSE 100 has returned an average nominal return of around 7.11% since inception.
Over the same period, RPI inflation has averaged 3.70%, implying a real return of 3.41% on the FTSE 100.
3. Can index funds lose money?
Yes, index funds can lose money as they can go down or up in value like stocks.
However, when index funds fall in value, the loss only becomes real when you sell your index funds.
If you don't sell, any losses you see are only paper losses. In general, index funds go up in value over time.
4. Are index funds tax-free UK?
Yes and No. If you invest in a tax-efficient account like a Stocks and Shares ISA, then your index funds are tax-free when you sell.
If you invest in index funds in a Pension or SIPP , then you get to see the investment grow and you get 25% of it is tax-free and 75% taxable at retirement.
Finally, if you invest via a General Investment Account, then you get taxed if your gains exceed your annual Capital Gains Tax allowance.
5. How do you earn money from index funds?
Index funds make you money as an investor by the underlying value of the stocks they invest in going up.
You get 2 types of returns from index funds.
The first is the ‘capital return' from the value of your investment going up.
And the second is the ‘income return' from any dividends you receive from the index funds.
Capital Return + Income Return = Total Return from index funds.
What To Read Next On Index Funds UK:
- Recommended: Super Simple Investing course
- How to Invest in Stocks: Step-by-Step
- PensionBee Review: Could Pension Savings Be Simpler?
- Best Vanguard Index Funds and ETFs to Invest In
What To Watch Next On Index Funds UK:
We would love to hear from you in the comments. What questions do you have about investing in index funds in the UK? Please share below.
Thanks gor providing this. Now looking at high risk investments, to see how my appetite can match it. What do you think?
Do you also have a blog for pension (for self employed) and the best platform to use that will incur lesser fees.
Thanks in advance.
The Humble Penny says
Hi Tee, we are soon to publish a UK Pensions guide. So watch out for that later today most likely 🙂
A provider I’d suggest you use is PensionBee – https://thehumblepenny.com/PensionBee (referral link). We use them and love what they do. They also help you combine all your old pensions into one plan online for free.
Ahead of our UK guide to Pensions, here are posts to read:
Retirement Savings hacks for the self-employed:
How to build a £100K Pension in 5 years:
Paul S-T says
Hello Ken and Mary, thanks for the article and all you do. I currently invest in ETFs and would value your insight regarding how you’ve navigated choosing particular funds from the perspective of being Christians. Like yourselves I’m also a Christian and am thinking about how to navigate potentially not wanting to generate income from particular sources (i.e. adult entertainment) and how this may look like.
What sort of considerations did you have to make and decide on in your own journey?
The Humble Penny says
Hey Paul, what a fascinating question :). It’s powerful to see that there is more of a focus on ethical investing or investing more generally with a focus on values. The way we approached this as people of faith is to make investments that support our value system and beliefs. More specifically, we do this by looking at what an Index Fund or ETFs is investing in specifically i.e. what companies does it invest in and what do they do? This can be a challenging exercise depending on how thorough you want to be but I think the key principle here is to vote with your money and make investments that support your beliefs. This will not work for everyone as some people just invest and never think about what their money supports, and that’s ok. But I think there will continue to be a growing drive towards this type of investing. By the way, you can see the detail of the investments by looking in the information provided by the fund provider on their website. They usually breakdown what the fund invests in. When you use an investment screener, you can also avoid certain things like tobacco, firearms, etc. This blog post on ethical investing is worth a read: https://thehumblepenny.com/how-to-start-ethical-investing/