What is an Index Fund?

If there’s one concept that underpins almost everything on this site, it’s the index fund. It’s the investment vehicle used by millions of ordinary investors to build long-term wealth, and consistently, over decades, it outperforms the majority of professionally managed funds.

Here’s what it is, how it works, and why it’s so powerful.

Start With the Index

An index is simply a list of companies grouped by a set of rules. The FTSE 100, for example, is an index of the 100 largest companies listed on the London Stock Exchange. The S&P 500 is an index of 500 large US companies. The FTSE All-World index covers thousands of companies across both developed and emerging markets worldwide.

These indices are calculated continuously, as company values rise and fall, their weighting in the index changes. Companies that shrink fall out; companies that grow get added. The index itself is just a measurement tool.

What an Index Fund Actually Does

An index fund is a fund that simply buys all, or a representative sample, of the companies in a chosen index, in proportion to their size. It doesn’t try to pick winners or avoid losers. It just owns everything the index owns.

A simple example The FTSE All-World index contains thousands of companies. A FTSE All-World index fund buys shares in all of those companies, weighted by their market size. Apple is one of the world’s largest companies, so it makes up a larger portion of the fund than, say, a smaller Japanese manufacturer. When you invest in the fund, you own a tiny slice of all of them.

The fund’s job isn’t to beat the market. It’s to match it. Whatever the index returns, the fund returns, minus a small fee for running the operation.

This approach is called passive investing, and it sits in contrast to active investing, where fund managers try to pick stocks they believe will outperform the market.

Why Passive Beats Active (Most of the Time)

The natural question is: why would you want to just match the market? Surely a skilled fund manager can do better?

The data says otherwise, consistently, over decades, across markets.

• The S&P SPIVA report, which tracks active fund performance against benchmarks, consistently shows that over 10-15 year periods, around 85-90% of actively managed funds underperform their benchmark index
• The ones that do outperform in one period rarely continue to do so in the next
• After accounting for the higher fees active funds charge, the underperformance is even more pronounced

This isn’t because professional fund managers are incompetent. Many are brilliant. The problem is that they’re competing against each other in an efficient market, paying for research and trading costs, and charging fees, all of which eat into returns. The index, by definition, captures the average return of the market before all those costs.

The index fund advantage When you invest in an index fund, you’re not trying to beat the market. You’re accepting the market return, which, over the long run, has beaten the majority of active managers anyway. You do this at very low cost, with very little effort, and with broad diversification built in. It’s not exciting. It’s extremely effective.

Types of Index Fund

You’ll encounter two main types of index fund, and while they work slightly differently, the end result for an everyday investor is broadly the same.

Unit trusts and OEICs

These are traditional fund structures where you buy units in the fund. They’re priced once a day, and you buy and sell at that daily price. Many pension funds and ISA platforms offer these. Vanguard’s LifeStrategy funds are a well-known example.

ETFs (Exchange Traded Funds)

ETFs work just like index funds but are listed on a stock exchange and traded throughout the day like shares. They tend to have slightly lower ongoing charges than equivalent unit trusts and are available on almost all UK platforms. Vanguard’s FTSE All-World ETF (VWRP) is one of the most popular for UK investors.

For most beginners the difference between the two is minor. Your platform may offer one or both, either works well.

What Does ‘Diversification’ Mean in Practice?

One of the biggest advantages of a global index fund is instant diversification. When you invest in a fund tracking the FTSE All-World, you own a piece of thousands of companies across dozens of countries. If one company collapses entirely, which happens, it barely moves your overall portfolio.

Compare that to someone who puts all their money into a single company’s shares. If that company has a bad year, their investment has a bad year. If it fails, they lose everything. An index fund makes that concentration risk essentially impossible.

Diversification in numbers A single global index fund might contain shares in Apple, Toyota, HSBC, Samsung, Nestle, Tata, and thousands of others, spread across the US, UK, Europe, Japan, China, Australia and more. No single company or country failure can seriously damage your overall portfolio. This is diversification doing exactly what it should.

How to Actually Buy an Index Fund

You buy an index fund through an investment platform, either inside a tax-efficient wrapper like a Stocks and Shares ISA, or in a general investment account. The process is straightforward:

1. Open an account on a platform (see our UK platform comparison)
2. Choose your account type, a Stocks and Shares ISA is the best starting point for most UK investors
3. Search for the fund you want by name or ticker, e.g. VWRP for Vanguard FTSE All-World ETF
4. Choose how much to invest and whether to set up a regular monthly investment
5. Confirm the purchase and leave it to grow

Most platforms let you set up a regular investment so the same amount goes in automatically every month. This means you’re buying more units when prices are low and fewer when prices are high, a process called pound-cost averaging that smooths out market volatility over time.

What to Look for in an Index Fund

Factor	What to Look For
Low ongoing charge	Look for funds with an ongoing charge (OCF) of 0.25% or below. Many excellent global index funds charge 0.10-0.22%.
Broad diversification	A fund tracking global markets (thousands of companies) is better diversified than one tracking a single country or sector.
Large fund size	Larger funds are more established and have lower trading costs built in. A fund with billions under management is preferable to a tiny new one.
Reputable provider	Vanguard, BlackRock (iShares), and Fidelity are the major index fund providers. All are well-regulated and long-established.
Accumulation vs Income	Accumulation (Acc) funds reinvest dividends automatically, better for long-term growth. Income (Inc or Dist) funds pay dividends out in cash. For most long-term investors, Acc is the right choice.

A Few Index Funds Worth Knowing About

We don’t recommend specific funds as financial advice, but these are commonly used by UK passive investors and appear frequently in discussions about long-term investing:

• Vanguard FTSE All-World ETF (VWRP), global markets, 0.22% OCF, accumulation
• iShares Core MSCI World ETF (IWDG/SWDA), developed markets, 0.20% OCF
• Vanguard LifeStrategy 100% Equity, global fund-of-funds, 0.22% OCF, available as a unit trust on many platforms
• Fidelity Index World Fund, developed markets, 0.12% OCF, very low cost

This is not a fund recommendation The funds listed above are examples of commonly discussed index funds in UK personal finance communities. Mentioning them here is not a recommendation to buy them. Your choice of fund should reflect your own goals, timeline, and risk tolerance. All investments can fall in value.

Not financial advice This page explains how index funds work as an educational overview. It is not tailored investment advice. Please consider your own circumstances before making any investment decisions.

What Next?

Now you know what index funds are, the logical next question is what they cost to run, and why that matters far more than most people realise. Our page on why fees destroy your returns puts very concrete numbers on it. Or if you’re ready to look at how to hold them in the most tax-efficient way, head to the UK Investing section.