Index-tracking funds offer an easy, cheap and non-frightening way to invest in the stock market…and it works!
Also known as ‘trackers’, this investment type is a no-fuss way to put money into the stock market.
As always, investment in the stock market runs the risk of getting back less than you invested. That’s why you should always invest for the long-term, at least five years, to see returns.
Here’s your quick guide to index-tracking funds and how to invest in them today.
- What exactly are index-tracking funds?
- Will I make or lose money?
- How do I invest?
- Get it wrapped in an ISA or put it into your own ISA wrapper
First, let’s look at what the stock market actually is.
A company gets listed on the stock market once it’s met certain strict regulations. You can then buy a little part of that company, called a share. When the company does well, your share price goes up – and you often receive an income from dividends, when the company distributes some profits to shareholders.
You buy as little as one share in one company – but it’s better to buy several shares in a range of companies. This is called ‘diversifying your portfolio’. It mitigates some risk: if one of your share companies doesn’t perform well, but another does brilliantly, you’ll lose on one but gain overall.
How do tracker funds come into it?
Tracker funds aren’t like a single company that you buy shares in. Instead, these funds track (see? Clue is in the name!) a part of a stock market index. Your money is invested in every company in that defined index.
When the index average goes up – or down – your share value does the same. This varies every day as the markets change.
Indices track across the globe, too. You might follow a UK-specific index like the FTSE 100, which is made up of the top 100 companies in the UK. You could also invest in an overseas index tracker – which is a much simpler way to invest in global funds than buying shares.
The most common indices you’ll see tracker funds follow include:
- FTSE 100 (the top 100 companies listed on the London Stock Exchange)
- FTSE 250 (the top 250 companies listed on the LSE)
- FTSE All-Share (all companies listed on the LSE)
- AIM (Smaller companies not yet listed on the LSE)
- Dow Jones (An American stock exchange)
- Nasdaq (Another American exchange)
- Nikkei (The exchange in Japan)
- Hang Seng (Hong Kong’s exchange)
- DAX (The German exchange)
Investing using index trackers means you can put your money into several of these global exchanges to diversify your portfolio.
However, if you want to invest in the British indices before branching out internationally, take a look at the differences between the FTSE 100, FTSE 250, and FTSE All-Share.
the different types of indices to track
We recommend you start by tracking one of the three main UK indicies. The FTSE 100 and the FTSE All-Share tend to perform pretty similarly, but the third, the FTSE 250, goes up and down a little more because it’s made up of middle-sized companies, for which the prices can be a bit more volatile.
Any company listed on the London Stock Exchange must adhere to strict financial regulations set by the Financial Conduct Authority. The only market that companies don’t have to meet such stringent regulations for is the Alternative Investment Market, which is often for smaller or newer companies and is regulated directly by the London Stock Exchange (instead of UKLA).
We’ll focus on the FTSE indices here because AIM investments suit more experienced investors.
The FTSE 100
This measures the largest 100 companies in the UK by value.
The top 100 companies represent about 80% of the value of the whole of the London-based market (the FTSE All-Share), so you can get a pretty good idea of what the stock market as a whole is doing from how these top 100 companies are performing. This is why they report on the FTSE 100 in the news – if the FTSE 100 is up a few points then the overall feeling is positive – companies are generally perceived to be doing well.
The FTSE 250
The next 250 biggest companies in size make up the FTSE 250 – in other words, the companies ranked 101 to 350 in the market. Companies in this index are generally known as the ‘mid-caps’, meaning that they have a capitalisation (what they would be worth if you sold them) that is somewhere in the middle between the FTSE 100 and all the other tiddly little companies that are listed.
Interestingly, many of the traditionally ‘British’ companies, like manufacturers and house-building companies, are often found in the FTSE 250. For that reason, investors often choose to track this index if they believe the next few years will be bright for the British economy. They’ll look for signals such as a falling unemployment rate, which means more people are holding down jobs and able to spend more on housing, travel and shopping.
The FTSE All-Share
This measures the performance of the major part of the companies (around 700 of them) listed on the London Stock Exchange. This includes each one that sells shares to the public, from the very big household names like BT to the tiddlers, such as estate agents. Although it includes all of the publicly listed companies in the country it moves up and down in a similar way to the FTSE 100 because the first hundred companies in the index account for the vast majority of the wealth of the whole lot.
The rollercoaster nature of the FTSE
If you invest in a FTSE 100 index-tracking fund, your money will be spread over all one hundred companies in this index. This means that you will be investing in at least 100 companies all in one go, though you will have a different amount in each one.
Over time, the net effect has been that these funds have gone up. Historically, the stock market has always gone upwards, though in a very bumpy way. Sometimes it goes down for a few years but then it goes up again for a few more years. After all, that is what it has done for the last hundred years or so.
Trackers charge less than the managed funds because they’re run by computers which, unlike your average City fund manager, don’t expect a new Porsche Boxster and a holiday in the Bahamas every year. In fact, you shouldn’t pay more than 1% a year in management fees for your index-tracker, and many charge less than 0.2%. Index-tracking funds are relatively easy to invest in. The only hard part is choosing which one.
It’s very simple to invest in an index-tracking fund. You can even do it online – there’s no need for a middleman stockbroker.
Popular investment platforms we like include:
These platforms, and others like eToro, also offer a similar type of tracker fund called an Exchange-Traded Fund. These operate in the same way as an index-tracker, but follow a range of market sections, such as commodities or even countries. You can read more about them in our ETF investing article here.
Make sure you look at and compare the account fees before choosing the platform that’s right for you. When you’ve found the right platform for you, sign up to an online account. You need to confirm some details, such as your UK residency status, age, and address.Then, transfer your money to the account. Use the information the platform provides about the index-tracker funds to choose ones you want to invest in. When you’re ready, use the money you’ve transferred to your account to buy shares in that fund.
You also get an option to have some or all of your investment wrapped in a tax-saving ISA. This is a good thing to do if you haven’t already used up your stocks and shares ISA allowance.
Many companies that provide tracker funds also offer them pre-wrapped in an ISA which makes it easier. Legal & General and AJ Bell Youinvest, for example, both offer their funds already wrapped in an ISA.
You can split your personal allowance between an equities ISA and cash ISA.
The provider asks if you want to put in just a lump sum or make regular monthly investments.It depends on your circumstances what you do here. If you have a lump of money to invest now then go ahead and put it in. But if you don’t, and you think you can afford a certain amount each month, then set that up as a direct debit from your bank account.
Sometimes, drip-feeding money regularly actually helps you to grow your wealth compared to a lump sum. If, for example, your £1000 investment buys 1000 shares at £1 in one month, the second month these shares might go down in price. Say you invested £500 in the first month for 500 shares; then the next month, you can buy 750 shares for another £500 investment. So, you could buy 1250 shares for the same £1000 investment over two months.
You could also set up an ISA wrapper of your own into which you put a tracker fund and some other investments, depending on what interests you.
Sitting on your investment
Setting up your online account still means there’s some paperwork involved. Once completed, you can invest!
It’s easy to ‘set and forget’ index-tracking funds. You don’t need to be as active as when you’ve invested in individual companies.
Leave your investments as long as you can, too. This helps you to ride out the inevitable bumps in the road every stock market investor experiences. When you invest via an ISA wrapper, you can also choose whether you want to automatically reinvest any profit or take it as cash. Reinvestment is, inevitably, the best option here if you can afford to leave your fund alone. Over time, the compound returns will grow significantly.
When you’re confident with investing in indices on the London Stock Exchange, consider branching out to a global index. This diversifies your portfolio to mitigate some risk – and is a fun way to stay interested in your investing, too!