Building A Portfolio: Index Funds
Index funds – what are they exactly? And what can they do for me?
The traditional image of investing on the stock market involved scanning huge columns of figures to see how individual companies are performing then grabbing the phone and shouting “Buy x! Sell y!” to a broker, who would then leap around making weird hand gestures and sweating a lot.
How things have changed. Sure, some investors still want the hands-on, real-time buzz you can only get from active portfolio management, but increasingly it’s passive investing that is making life easier for the money-minded.
So what it is?
It’s simple, actually. Passive investing means using a kind of mutual fund (one lump of money spread evenly between loads of different stocks) that “tracks” the market as a whole. So, if your market of choice is the FTSE All Share, you would effectively have a small share in every single company listed on it. When the market goes up, so does your money, and vice versa. If one day a new company is added to the market, the algorithm that controls your fund would add that in to your group of stocks. If one leaves, it automatically drops off your list.
Wait, so it’s all done by computer? Not a shouty man in a pinstripe suit?
Exactly. Which makes it much cheaper. Which is why it’s a cool way to invest! If you invest in an active fund you can expect to pay ongoing fees and charges ranging from around 0.65% to over 1% each year of your total investment in the fund vs. something as low as 0.07%, according to Barclays Smart Investor. It’s as simple as a computer program linking your figures up to the daily performance of the market. Plus you’re not paying tax on every sale, which is nice…
It sounds like a brave new world of investing!
It is. Until recently, there weren’t many passive funds available (and there are still way more active funds to choose from). But a new kind of tracker fund called an ETF - an Exchange Traded Fund – has made collective investment schemes readily available to ordinary individuals like us. According to The Motley Fool, the first ETF was launched in the US in 1993 and they have only been available to UK investors since 2000. Of all UK funds under management, three-quarter of assets are still actively managed according to Asset Management in the UK 2016-2017 by The Investment Association Annual Survey.
But can I make big bucks?
The key thing about following the market rather than taking punts on individual stocks is minimizing risk - while it does not guarantee against losses it should help you navigate through market volatility (markets going up and down). This is called diversification (across asset classes but also industries for exemple): “don't put all your eggs in one basket”. You’re probably not going to be losing fifty grand one day then making it back the next. And really, who wants to live with that kind of stress anyway? As with all investing, it pays to think mid- to long-term. And over five or ten years, index linked funds have been proven to be just as profitable as their roller-coaster cousins on the active investment scene. You can read more on vestpod.com here.
What’s the downside?
They’re not so great if you want to avoid, or focus on, certain types of company, for ethical or financial reasons, as you have no choice what you’re investing in. If you want nothing to do with oil companies or feel like you want to focus on a particularly “hot” specialist area, like technology or property (or companies with female CEOs!) you may need to do some proper search to find the right index fund or talk to an expert fund manager. There are some amazing, highly skilled portfolio managers out there who can make huge profits on active funds. It just depends how you want to live your financial life…
In conclusion, index linked funds are an easy, cost-effective saving strategy for beginners, the risk averse and those who don’t want to invest too much time worrying about the ups and downs of the stock market. If that sounds like you, now’s the time to get off your butt and get passive!
Remember that markets go up and down and that past performance is not an indicator of the future! Also it can be a good idea to have repaid all expensive debts and have some emergency savings before you start investing.