What is an index fund and which have been the best performing?

An index fund is an investment vehicle that tracks an index. An index tracks how stock a stock market, or other assets, perform that meet certain criteria. For example, the S&P 500 includes the largest 500 companies in the US by market cap. The criteria will remain the same, even though the stocks within the 500 may change over time. Therefore, the index shows how this collection of stocks is performing.

Investors can’t invest in an index directly; rather, they need to buy a product based on an index, which could come in the form of an ETF or mutual fund. The fund tries to essentially replicate what the index is doing, so the index fund and index have roughly the same return, minus any fees charged by the index fund.

There are thousands of index funds tracking all sorts of indices. For example, there are clean energy and solar funds, and index funds related to sectors and industries, bonds, new technologies, IPOs, currencies, growth stocks, value stocks, and more.

Index funds are popular, so here are some of the benefits:

There are also some disadvantages of index funds. These can include:

There are a lot of different types of index funds and choosing one can be overwhelming. Here are some tips to help break down the choice:

For distributing ETFs and mutual funds, dividends are received by the index fund, then paid out to owners of the fund. Typically, this is done quarterly, but the payout frequency can vary by product. The index fund’s prospectus or webpage should show the yield investors have received from holding the fund.

The dividend yield is the number of yearly dividends divided by the price of the index fund. For example, if a fund has a dividend payout of £3 and the price of the index fund is currently £150, the yield is 2%. Yield will change any time the dividend payout changes or the index fund price changes.

A fund may accumulate dividends instead of distributing them. The fund manager can then use dividends payments to reinvest in the fund. In this case, the shareholder doesn’t receive the dividends, rather the dividends are kept inside the fund.

Tax laws vary by jurisdiction. For distributing ETFs and funds, investors will typically need to pay taxes on the dividends received unless they hold the fund within a tax-protected account, such as an ISA.

For non-distributing ETFs and funds, taxes don’t typically need to be paid up until you make £2,000 in dividends, which is the dividend tax free allowance amount, according to Barclays.

Let’s assume an investor has funds available in their brokerage, ISA or spread betting account. They decide that they want to invest that money into a couple of index funds. They choose to buy ETFs since they can be bought and sold throughout the day with ease.

They do some research, potentially looking at what index fund’s past performance has been (discussed in the section below), or what indices may do well in the future. They choose to buy the iShares Core FTSE 100 ETF (ISF).

They then place a buy order for the index funds they choose. If available with their chosen broker, they can use a market order to buy at the current offer price, or they can use a limit order to try to buy it at a lower price. For example, if the offer price is $692.60, they could use a market order to purchase the ETF at that price right now. Or, after studying the chart, they may decide to buy on a pullback in price and will place an order of $685, for example.

There is no limit on how long the trade is held. It can be held short-term, for a matter of seconds or minutes, a few days to a few months, or it can be held over the long-term for many years as an investment.

Below are the top-performing funds according to a share price increase over the past five years, as of early October 2021. Only funds with at least an average daily volume of 100,000 trades are included.

Here are the index funds with the lowest expense ratios. Only funds with at least 100,000 share daily average volume are included.

Global stock markets will vary in performance, but the average returns in dominant benchmark indices across the US are as follows:

Both exchange-traded funds and mutual funds can be held inside an ISA, although any funds bought and held in the account must be authorised for sale by the Financial Conduct Authority (FCA). This means most ETFs offered outside of the UK, such as those that trade on US exchanges, wouldn’t qualify to be held inside an ISA.

Foreign shares, which trade on a recognised exchange, are permitted to be held inside an ISA. The rules vary based on the exact product you wish to hold.

Purchasing a mutual fund index fund or an ETF will often involve a commission. Commissions vary by product and broker.

There is also a yearly management fee. This can range from less than 0.1% to several percent per year. This is called the expense ratio and is all the costs associated with running the fund. It is deducted from the fund each year.

When you are spread betting on an index fund, there is a small overnight holding cost​​ if the position is held for more than one day.

For buy-and-hold investors, the primary thing to be aware of when investing in index funds is portfolio management. Portfolio management includes how and when you rebalance​​ and how you diversify the portfolio​​.

Portfolio rebalancing is keeping the desired asset mix in the portfolio. For example, if you own five index ETFs and one does extremely well, over time, that index will compose more of the portfolio than it once did. Rebalancing is buying and selling the index funds to bring the portfolio into proper balance.

This also leads to diversification and deciding how many index funds will be in the portfolio and what weighting each will be given. A conservative approach may be to have the most capital in several diversified funds – domestic and international – with only a small amount in more speculative or higher volatility funds. Another investor may prefer more capital in more speculative funds.

Shorter-term traders can use index funds to capitalise on trends. If technology stocks are popular, for example, they could buy a technology index fund. Or, if the price of oil is rising, an oil or oil producer index fund may benefit.

This is a personal choice depending on how much diversification is desired for the portfolio. An index fund holding 500 companies is diversified by most people’s standards. Yet, those are all US companies and large ones. Some people may wish to add index funds from other countries or an index that includes smaller companies.

Since index funds are a cost-effective way to gain exposure to a large basket of stocks with one transaction, you should weigh the diversification benefits versus the average return of each index fund.

Some index funds have higher average returns than others. Including more higher-returning funds will theoretically tend to increase the long-term return of the portfolio. Including more lower-return funds may pull down the average return.

A fund’s yield refers to the dividends received as a percentage of the price for holding the investment over a set period, usually one year.

Total return is the change in the value of the index fund itself over the holding period or over a set period.

For example, if an investor buys an index fund or ETF at a price of £100, and it tends to pay a £1 dividend each year, its yield is 1%. The current yield is the expected dividend amount divided by the current price of the asset.

But say, over the course of the year, the dividends are paid, and the index fund or ETF is now trading at £110. The capital gain increase is £10, and the fund also paid a dividend, which is also a return.

Factoring that in, the total return is £10 + £1 = £11 / £100 = 11%.