Index Funds and ETFs Explained
An index fund buys the whole market rather than trying to pick the winners, which turns out to beat most of the people trying to pick them.
Key points
- An index fund replicates a market index rather than attempting to outperform it.
- Low cost is the main structural advantage and it compounds over decades.
- ETFs trade like shares; index funds price once a day. Both can track the same index.
- Check the index, the total cost, the size of the fund and whether it is accumulating or distributing.
How they work
An index is a defined list of securities with rules for inclusion — the largest companies in a market, or all listed companies above a size threshold. An index fund holds those securities in those proportions, so its return matches the index minus costs.
There is no manager deciding what looks cheap. When a company enters or leaves the index, the fund follows. That absence of discretion is what makes it cheap to run, and the cost difference is the main reason it works.
The evidence is well established. The SPIVA reports, which track this systematically, consistently find that over ten- and fifteen-year periods the large majority of active funds underperform their benchmark after fees. The proportion varies by market and period; the direction does not.
The costs, and why they matter so much
| Cost | Typical for an index fund | Typical for an active fund |
|---|---|---|
| Ongoing charge (OCF/TER) | 0.05–0.25 % | 0.7–1.5 % |
| Platform fee | 0–0.45 % | 0–0.45 % |
| Trading costs | Low (little turnover) | Higher |
| Transaction fee per trade | £0–£10 for ETFs | Varies |
The compounding effect is larger than it looks. On £100,000 over 30 years at 7 % gross:
- At 0.15 % total cost: about £728,000
- At 1.15 % total cost: about £549,000
A one-percentage-point difference costs roughly £179,000 — a quarter of the outcome — for no additional benefit that the evidence supports. This is why cost is the factor most worth optimising, and one of the few you can control with certainty.
Index funds versus ETFs
| Index fund (OEIC/mutual) | ETF | |
|---|---|---|
| Trading | Once a day at a single price | Throughout the day, like a share |
| Cost to trade | Usually free | May be a per-trade commission and a spread |
| Minimum | Often very low | One share, or fractional where offered |
| Regular investing | Straightforward | Supported by most platforms |
| Best for | Monthly contributions | Lump sums, wider choice of markets |
Both can track the same index at similar cost. For someone contributing monthly on a platform that charges per trade, index funds are often simpler. For lump sums or for access to specific markets, ETFs offer more choice.
One structural note: most ETFs hold the underlying securities physically, but some are synthetic, using derivatives to replicate the index. Synthetic ETFs can track more precisely and introduce counterparty risk. For a core long-term holding, physical replication is the simpler choice.
What to check before buying
- Which index does it track? “Global” funds vary enormously — some exclude emerging markets, some are heavily concentrated in a single country. Read what is actually in it.
- Total cost, not just the headline charge. Ongoing charge plus platform fee plus trading costs.
- Tracking difference. How closely it has actually followed the index over several years, which is a better measure than the stated tracking error.
- Fund size. Very small funds can close and force a disposal at an inconvenient time.
- Accumulating or distributing. Accumulating reinvests dividends automatically, which is simpler for long-term growth. Distributing pays them out, which suits someone drawing income and may have different tax consequences.
- Domicile and currency. Affects withholding tax on dividends and adds currency exposure. Usually secondary, occasionally significant.
Once bought, the correct action is generally nothing. Rebalance annually if you hold several funds, and otherwise leave it alone.
Frequently asked questions
Are index funds safe?
They are diversified, not safe. A global equity index fund can and does fall 30 % or more in a bad year. Diversification removes the risk of a single company ruining you; it does not remove market risk.
What if everyone buys index funds?
An interesting theoretical question with no practical consequence at current levels. Active management would become more profitable as prices became less efficient, drawing capital back. It is not a reason to pay higher fees today.
Should I buy a global fund or several regional ones?
A single global fund is simpler, automatically rebalances between regions, and is adequate for most people. Splitting regions gives you control over weightings and requires you to rebalance and to have a view — which most people do not.
Accumulating or distributing?
Accumulating for long-term growth, since dividends are reinvested automatically without a transaction. Distributing if you need the income. Tax treatment differs by jurisdiction, and in a tax-advantaged account the distinction usually matters less.