Index Funds – What they are and why you need them

Index funds aren’t complicated. They are just a pool of different investors money that invest in an index. An example is the FTSE 100 index or the Footsie. This is basically a list of the 100 biggest companies in the UK. An FSTE 100 index fund would just invest in each one of these companies. The fund will usually invest in a company in proportion to that companies share of the market. For example, if the biggest company is Royal Dutch Shell and its share of the market is 11% then 11% of the funds money will be invested in Royal Dutch Shell. Likewise, if the second biggest company is HSBC and its share of the market is 7% then the fund will invest 7% of its money in HSBC and so on. The fund does this until it has divided all its money between all 100 companies. Consequently, if you invest £100 pounds in an FTSE 100 index fund £11 will be automatically invested in Royal Dutch Shell shares and £7 in HSBC shares.

Spread your bets

Index funds are great because they allow you to spread your bets across a range of different companies. Betting on one company might make you rich if you are lucky, but if you are not you may lose all your money. Though unlikely, it is possible that HSBC may go bust, but the chances of HSBC, Shell, BP, British American Tobacco, Glaxo Smith Kline, Astra Zeneca, Diageo, Vodafone, Rio Tinto, and all the other 90 companies in an FSTE100 index fund all going bust at the same time is pretty much zero.

Unit trusts and mutual funds

Of course unit trusts, sometimes called mutual funds also invest their money across different companies. The difference is that these funds have a fund manager and fund managers have one major disadvantage. They are usually expensive. Typical FTSE 100 index funds charge 0.07%, where as fund managers often charge around 2%. Often people get mislead into thinking the fees they are paying aren’t expensive at all. They hear 1 or 2% and think that’s nothing, but here’s what Charles Schwab, the founder and Chairman of Charles Schwab Corporation (one of the first and biggest discount brokerages) had to say during an interview with Tony Robbins in Money Master the Game, “For every 1% over the lifetime of investing, it’s 20% of your money you’re giving up. Give up 2%, that’s 40%. Give up 3%, that’s 60%.” Working back from that, 0.5% is 10% of your money which is more acceptable. Anything less than that can be considered pretty reasonable, I think.

Don’t we need a fund manager

Of course there are some who argue that it is worth paying the extra for a fund manager to pick stocks rather than just blindly following an index. Unfortunately, there’s a mountain of research out there that proves most fund managers don’t do any better than an index. In fact, many do worse. Just to be clear, it doesn’t mean there isn’t anybody who can do better than an index. It just means those people are few and far between. Most fund managers can’t do it and if they can’t do it, the chances of an individual investor doing it are even smaller. Even the very few people who can don’t recommend it. Here’s what Warren Buffet, who many consider to be the greatest investor of our time has to say: “If you invested in a very low-cost index fund — where you don’t put the money in at one time, but average in over 10 years you’ll do better than 90% of people who start investing at the same time.”

It would take a brave soul to argue with the greatest investor of out time!