How to Invest in Index Funds in the UK

UK index funds are a popular way for beginners to invest in the stock market. Why? Because when you invest in an index fund, you get the opportunity to own a wide range of different companies at an extremely low cost.

The firm managing the index fund does all the hard work for you. They’ll work out how much to invest in each company, make any adjustments along the way as required, and collect all the dividends on your behalf.

In other words, it pretty much puts your investments on auto-pilot. And that allows you to sit back and hopefully just enjoy the long-term gains the stock market has historically delivered.

What is an index fund?

UK index funds and global index funds tend to be the most popular among UK investors. If you want to invest in UK index funds, you’ll probably be following indexes like the FTSE 100, FTSE 250, and FTSE All-Share. In the US, the Dow Jones Industrial Average and the S&P 500 are examples of indexes.

The numbers often indicate the number of companies within that index. For example, the FTSE 100 covers the largest 100 companies listed on the London Stock Exchange.

It’s important to understand that there are many different types of indexes. Some cover thousands of different companies and allow you to invest on a global basis.

Others are much more focused on a single country or type of industry and may include just a few dozen companies.

How do index funds work?

These financial instruments are designed to mimic the positions and, therefore, performance of a specific index. Investors buying shares in an index tracker fund are effectively putting their money into a giant pot with lots of other investors. This capital is then invested by the fund manager into all the companies of the underlying index.

Since the manager effectively does all the work, investing in an index fund is arguably the easiest way for beginners to put their money to work in equities. However, this service isn’t free. 

Every year, investors pay a recurring management fee, which is often a percentage of the amount each individual has invested. Today, most index funds are actually run by robots rather than humans. While that’s certainly less personal, it does mean that management fees have dropped drastically over the years. 

Best index funds in the UK

iShares Core FTSE 100 ETF

Enables investors to mimic the UK’s leading index containing the top 100 companies. Collectively, these businesses represent roughly 80% of the value on the London Stock Exchange.

Historically the index hasn’t delivered the greatest growth. However, with an average dividend yield hovering around 4%, investors have still managed to grow significant wealth over time.

SPDR S&P 500 UCITS ETF

Similar to the FTSE 100, the S&P 500 contains the largest 500 companies in the US. While the index is listed on the London Stock Exchange, its contents is purely American stocks. 

Historically, the S&P 500 has been a terrific source of growth. On average, the index delivers an annualised return of around 10%. However, there have been multiple years where the growth has been in excess of 20%! 

Vanguard FTSE 250 UCTIS ETF

This index tracker enables investors to invest in a broader range of companies in the UK. The FTSE 250 index contains all the companies of the FTSE 100 along with an additional 150 businesses with smaller market capitalisations. 

This does open the door to more volatility. However, the index has historically delivered higher returns than the FTSE 100 alone.

Which index fund has the best returns?

Since index funds only mimic an underlying index, their performance is driven almost entirely by the index being tracked. Obviously, management fees also eat into returns. But this expense has slowly become near-negligible over the years. So, when hunting for the best returns, this largely boils down to the choice of index rather than the choice of index fund.

Over the last five years, the UK’s flagship indices have produced a wide range of results, with British small-cap stocks leading the charge.

However, despite being home to many terrific businesses, returns have paled in comparison to some of the indices across the pond in the US.

There are a variety of reasons behind the difference in performance between UK and US shares. However, a large contributing factor is the UK’s lack of exposure to the technology sector. Looking at just the S&P 500, almost a third of its constituents operate within the tech industry, compared to just 2% of the FTSE 100.

So, does that make US-focused index funds the best? Not necessarily.

Bigger is not always better

Even when indirectly investing in American businesses, investor’s portfolios are exposed to foreign currency exchange risk. Given that both the US dollar and the UK pound are relatively stable, this doesn’t necessarily spark concern in the short term. However, in the long run, even stable currencies can gradually shift in an unfavourable direction.

There is also the matter of risk. While US stocks have outperformed over the last five years, it hasn’t been a smooth journey. During the recent stock market correction in 2022, the S&P 500 at one point lost almost a third of its value in a few short months. Meanwhile, the FTSE 100 was actually up due to its constituents being far more resilient to the shifting economic conditions.

Therefore, investors need to consider their personal objectives, risk tolerance, and time horizon before deciding on which index is the right pick for their portfolio.

Should I put all my money into the FTSE 100?

Let’s assume, after careful consideration, a conservative investor decides the FTSE 100 is the best index to grow their wealth. Should they put all their money into just a single index?

Investing through index funds comes with a lot of advantages. A portfolio is effectively put on autopilot as stock picking, asset allocation, and rebalancing is all taken care of. Portfolios become automatically diversified as money is indirectly distributed across a wide range of businesses and industries. And since all of this is achieved with a single transaction, the trading costs are also minimised.

However, there are some drawbacks. A portfolio will only ever grow as fast as the underlying index being tracked, making it impossible to earn market-beating returns. Index funds also mean investors can’t pick and choose between companies within an index. So, if there are any specific companies an investor doesn’t want to own, such as a tobacco company, an index fund won’t provide this flexibility.

Should I invest in an index fund or ETF?

An index fund and an exchange-traded fund (ETF) both allow you to track a stock market index for a very low cost. But they work in slightly different ways.

The price of an index fund only changes once a day. Your investing platform collects all the buy and sell orders it gets from all its customers and puts them all through at the new, updated price in one fell swoop.

ETFs are traded on the stock market, so their prices changes on a minute-by-minute basis while that market is open. You decide exactly when you want to buy and sell, and the transaction takes place straight away.

One other key point to be aware of when you invest in index funds and ETFs is that investing platforms may charge you slightly differently fees for them.

With ETFs, you are normally charged a small commission each time you buy or sell. It’s the same amount, whatever the size of your transaction.

With index funds, you are usually charged a small percentage of the value of your holdings each year.

As a general rule, investing in index funds is usually cheaper for smaller amounts and for those that make regular purchases. ETFs can be more cost-effective if you deal in larger amounts.

What to know before investing in index funds

Choose an investing platform

In order to invest in index funds, you’ll need an account with an investing platform. These allow you to buy index funds operated by many different companies.

Some companies that run index trackers themselves (e.g., Vanguard) may offer accounts as well but this typically means you will be restricted to just their own funds.

Check out our top-rated investing platforms in the UK to find the right one for you.

Use ISAs and SIPPs

The Stocks and Shares ISA and Self-Invested Personal Pension (SIPP) are wrappers that can protect your investments from tax. Outside of these products, you may have to pay income tax on dividends received and capital tax gains on any profits.

When you start out investing, it’s easy to think you’ll never make enough to pay lots of tax. But, especially if you invest on a regular basis, your portfolio can grow a lot more quickly than you expect.

ISAs and SIPPs can save you from paying a lot of tax in the years ahead when you want to spend the money that you have invested. 

There are plenty of brokers offering a tax-efficient investment account. So, you’ll need to pick the broker that’s right for you.

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

Get used to ups and downs

Stock markets don’t go up in a straight line, so investing can feel like a bumpy ride at times. We think it’s important to stay invested for the long haul and to resist the temptation to jump in and out at the drop of a hat.

Start simple then branch out

With so many index funds available in the UK, it’s tempting to go racing off and buy something exotic and that has performed really well in the last few years.

We think that can be a mistake. Most investors should look at UK index funds or global index funds to start with and then maybe branch out into more specialised index funds as they get more comfortable with the process of investing.

How to invest in index funds in the UK

1.   Pick funds that reflect your investing strategy

There is an index fund for virtually every index in the world, so you can opt for whichever one reflects your investment strategy.

For example, you may believe emerging markets like Asia will become an increasingly important part of the world economy and therefore want to put more money into this region. Or you may think that sectors like technology and healthcare are vital to our future and put more emphasis on investing in these types companies instead.

Another rising investing approach is based on environmental, social & governance factors (ESG). And it’s entirely possible to get index funds that invest in an ethical and socially responsible way. 

Bog standard index funds tend to contain a lot of businesses that don’t meet ESG requirements, such as banks, miners, gambling, and tobacco companies. Depending on the way you would like to invest, it’s important to look at what your index fund includes and what it excludes.

2. Factor in ongoing costs

Index funds and ETFs have very low charges. These are paid for within the fund itself, meaning that they are effectively deducted from the unit price that you pay when you buy and sell. This means you don’t have to make a direct payment to cover them.

For this reason, the performance of an index fund will typically always slightly lag the index it’s trying to follow.

Match an index fund to your budget: index fund charges are very competitive these days. For the most popular indexes, where you may find several index funds are tracking exactly the same index, they tend to be very low. Investing in UK index funds tends to be cheapest in terms of charges.

3.   Invest via your chosen platform

The most common way people invest in index funds in the UK is through an investment platform. 

They offer index funds from all different sorts of providers and you can shelter your money from the taxman in an ISA or SIPP.

Many of them offer detailed information and research on index funds and highlight their favourites.

Investment platforms use two main charging structures. The first is based on a percentage of the money you have invested with them. The second is a flat monthly fee. Percentage-based fees are usually cheaper when you start investing, while flat fees offer more value as your portfolio grows in size.

4.   Consult an independent financial adviser

If you are unsure how to invest in UK index funds or you have a more complex financial situation, then one option is to ask an independent financial adviser to manage your investments for you.

A good adviser should be able to recommend a wide-ranging financial plan, designed to meet your long-term financial goals. They will monitor your investments and inform you if you need to make any adjustments.

However, perhaps their most important role is to guide you through periods when there’s turbulence in the financial markets.

Is investing in index funds right for you?

Investing in an index fund has a lot of advantages, especially for a new investor. It eliminates the need to learn anything about stock picking or understanding how to read a balance sheet. As such, investors can quickly put their money to work, and often forget about it since all the investment  portfolio management aspects of investing are also handled by a professional.

Sadly, this passive investing style has one major flaw. You’ll never be able to beat the market. 

Picking individual stocks has a higher degree of risk and requires far more dedication, research, and emotional discipline. But this comes with the potential to achieve higher returns each year. And in the long term, even the slightest outperformance can have enormous benefits in building wealth.