What is an index fund and how do you invest in one?

What is an index fund?

An index fund is a type of investment fund that aims to mirror the performance of a specific market index. Instead of trying to pick a handful of winners, the fund simply follows the underlying index as closely as possible. That could mean tracking a broad benchmark such as the FTSE 100, the S&P 500 or a global equity index, or it could mean following a narrower theme such as technology shares or government bonds.

This is the core answer to the question “what is an index fund?”. It is not a fund manager making frequent active decisions in an attempt to outperform the market. Instead, the fund is usually run in a passive way, with the goal being to match the market it tracks rather than beating it. 

For investors, that can make index funds easier to understand than many actively managed funds. You know what the fund is trying to do, you can see which index it follows, and costs are often lower because there is less research and trading involved. But that does not make them risk free. If the market the fund tracks falls, the value of the fund will generally fall too. But for many long-term investors, that straightforward structure is a large part of the appeal. 

How do index funds work?

To understand what an index fund is and how it works, it helps to think of it as a container. The fund holds a basket of investments designed to replicate a chosen index. If it tracks the FTSE 100, for example, it will usually hold shares in the companies that make up the FTSE 100, in roughly the same proportions. If it tracks a global index, it may hold hundreds or even thousands of shares across different countries and sectors.

As markets move, the value of the fund changes too. If the index rises, the fund should broadly rise with it, though your true returns will be minus costs. More expensive passive index funds can significantly reduce true returns over time. 

If the index falls, the fund is likely to fall as well. Some index funds physically hold the underlying assets, while others may use other methods to track the benchmark, but the objective is the same: to deliver returns that stay close to the chosen index over time.

This is why index funds investing is often described as passive investing. You are not asking a manager to decide which individual companies to buy and sell in pursuit of market-beating performance. You are choosing to follow the market itself. That can be useful for people who want broad diversification without having to research and manage a portfolio of individual shares on their own. 

However, the level of diversification depends on the broadness of the index itself, with something like the NASDAQ-100 Technology Sector Index offering much less diversificaftion than, say, the FTSE All-World Index. 

Why do investors use index funds?

The popularity of index funds comes down to a handful of practical advantages. 

• One is diversification. Buying a single share exposes you to the fortunes of one company, whereas buying into an index fund can spread your exposure across dozens, hundreds or even thousands of holdings. 
• Another is cost. Because index funds are usually passive, ongoing charges are often lower than for actively managed funds.
• That is one reason index funds are often mentioned in beginner content, and why so many of those new to the world of investing ask us to teach them the basics of how to start investing in index funds. 
• There is also a behavioural advantage. Many investors find that index funds remove some of the pressure to constantly pick stocks, react to headlines or try to time the market perfectly. Instead, they can focus on a regular, long-term approach.

For many people, the basics are exactly that: choose the market exposure you want, understand the risks, invest consistently and think in years rather than weeks.

That said, index funds are not automatically the right answer for every objective. A fund tracking UK large-cap shares will behave differently from a global equity fund, a bond fund or a technology-focused index tracker. The index you choose still matters, because that determines the kinds of companies or assets you will be exposed to. 

Stock index funds vs other fund types

Not all funds work in the same way. Stock index funds generally aim to track a share index, which means their value is linked to the performance of the stock market benchmark they follow. A FTSE 100 tracker, for example, gives exposure to large UK-listed companies, while a US index fund might track the US 500 or NASDAQ OMX Group Inc (24 Hours).

Actively managed funds are different. Rather than simply following an index, they rely on a manager or team to decide which investments to hold. The goal is often to outperform a benchmark, but that usually comes with higher charges (though costs vary) and no guarantee of better results. Investors who expand into investing in actively managed funds often mix them with passive index funds, although this comes with its own intricacies and risks – making our demo account a great place to practice in a non-live setting.

ETFs overlap with index funds in many cases because many ETFs also track an index, but ETFs trade on an exchange like shares, while some traditional index funds are bought and sold directly through a platform at daily pricing. Our own educational content also distinguishes between index funds and ETFs, which is worth understanding before you invest. 

A simple comparison

For a closer look, see Index funds vs ETFs and ETFs vs stocks. 

How to invest in index funds

If you are researching how to invest in index funds, the process is usually less complicated than people expect. In practice, it often comes down to choosing the right account, deciding what kind of market exposure you want, then selecting a fund that matches those goals.

1. Choose an investment account

You will first need an account that allows you to buy funds or related products. Depending on your goals, that might be a general investment account, a Stocks and Shares ISA or another tax-efficient wrapper.

2. Decide what you want your money to track

This is where many beginners go wrong (by jumping straight to brand names or headlines about the best index funds UK for beginners). A better starting point is to decide what exposure you actually want. Are you looking for UK shares, US shares, global markets or something more defensive? 

A UK-focused fund may feel familiar, but a global fund can provide broader diversification, a popular strategy being to invest in both S&P 500 and FTSE 100 index funds. Leaning towards capital gains and growth in the US and defensively minded dividend stocks in the UK can offer a mix that can be tailored to individual risk appetites.

3. Compare the fund itself

Once you know the market you want exposure to, compare factors such as ongoing charge, tracking approach, size, provider and whether income is distributed or reinvested. Investors should check the fund’s key investor information document (KIID). Small differences in cost can matter over the long term, especially if you are investing regularly over many years.

4. Invest in a way you can stick with

Some investors put in a lump sum, while others invest monthly - what's known as pound cost averaging. Regular investing can help smooth the effect of market swings, although it does not remove risk. The key is choosing an approach that fits your finances and time horizon rather than chasing what looks best in the moment. And remember, the value of your investment can fall as well as rise.

Popular index fund examples

Popular index funds to consider include:

• Vanguard FTSE 100 UCITS ETF

• Invesco QQQ Trust Series 1 - Daily

• iShares Core MSCI EAFE ETF

• SPDR Dow Jones REIT ETF

• WisdomTree Wheat

• Blackrock Income & Growth Investment Trust PLC

Are index funds a good choice for beginners?

For many people, yes. Index funds can offer a straightforward route into investing because they bundle lots of holdings together and follow a clear benchmark. That combination of simplicity and diversification is why they are so often popular as a starting point when people ask to be taught the basics of how to start investing in index funds.

But suitability still depends on the individual. A person investing for retirement in 20 years’ time may view volatility very differently from someone saving for a house deposit in two years. Even the most widely used index fund can be a poor fit if the investor does not understand what it tracks or cannot tolerate the ups and downs that come with market exposure.

The better way to frame the question is not whether index funds are universally good, but whether a specific fund suits your time horizon, risk tolerance and broader financial plan. That is where beginner education matters more than any headline about the “best” fund, the common view being that investing requires a 5+ year timeframe. 

How to start investing in index funds as a beginner

For anyone wondering how to start investing in index funds, the basics are usually less about finding a perfect product and more about getting the foundations right. Beginners are often better served by keeping things simple: invest in something broad, understand the fees, be realistic about risk and give the investment time to work.

A common mistake is to treat index funds as though they are guaranteed to rise because they are diversified. Diversification can reduce company-specific risk, but it does not shield you from market downturns. A global equity index fund can still fall sharply in a weak market. That is why time horizon matters.

If your money may be needed in the near future, stock-market index funds may not be the right place for it. Assets such as bonds, commodities and REITS that are non-correlated with equities can be popular portfolio diversifiers, as when shares fall, bonds often rise.

It also helps to remember that beginner-friendly does not necessarily mean basic. Some of the best UK index funds for beginners are simply broad, low-cost funds that do one job clearly and consistently. They are not exciting, but that is often the point.

The emphasis is on building exposure patiently rather than trying to predict the next short-term winner. For more background, see investing for beginners and how to start investing with £100. 

What to look for in UK index funds

When comparing UK index funds, the name alone is not enough. Two funds may both look like they target the same area but differ in cost, holdings, income treatment and structure. Before investing, it is worth checking a few core features.

• What index does it track? A FTSE 100 tracker behaves differently from a broader UK market fund.
• What are the fees? Lower costs can make a meaningful difference over time.
• How diversified is it? Some funds are broader than others.
• How are dividends handled? Some funds pay out income, while others reinvest it automatically. For assets held in a GIA, tax treatment of dividends can make funds which pay out income less advantageous to some investors.*
• Who is the provider? Size and reputation are not guarantees, but they can help when assessing a fund.

*Tax treatment varies by jurisdiction