Investing 101: Index Funds

Updated: Feb 9

Money has been pouring into passively managed index funds that track various benchmarks for the past decade, with Vanguard index funds leading the way. This article will articulate what an index fund is for beginners, before looking at why Vanguard is a pioneer within this particular area of investing.

What is an Index Fund?

An index fund is a portfolio of stocks created to mirror the performance of those stock, within a particular financial market index (for example the S&P500, the Russell 2000 or the Nasdaq Composite). They are passively managed, therefore have lower fees than actively managed funds. What this means is that, instead of individually buying shares in Facebook, Amazon, Alphabet, or Netflix, you could own a portion of them all within one technology index fund. And investors often pour money into these particular investment opportunities, as, in theory, over a long period of time, the market will outperform any single stock.

Ultimately, this grants investors exposure to the whole market in one, easy to use investment vehicle, that any lay investor can quickly understand.

Why are Vanguard the Largest Issuer of Mutual Funds?

There are an array of reasons for this:

1) They are renowned for having the lowest expense ratios in the industry. Expense ratios are ‘compensation for the management and issuance of the fund.’ Research has shown that Vanguard’s expense ratios are on average 82 per cent lower than the industry average. Therefore, investors pay the lowest fee for the management of their money.

Here is an example of why the expense ratio is important. If you invested £50,000 over 20 years, one would save £24,000 in expenses if the investment got an annual return of six per cent. It is hard to give up that amount of money, and thus Vanguard attracts a large proportion of index fund investors.

2) The fund’s performance: The fund aims generally to track the chosen benchmark, and Vanguard have measurable success in doing so, making it a reliable investment. For example, the Vanguard Total Shock Market Index Funds (VTSAX) created in April 1992 has achieved an annual return of 8.87% (as of March 2020).

3) Not very risky. With Vanguard funds holding £100s of billions, and holding companies within technology, finance, health care et al., the diversification gives investors another layer of reassurance. And with Vanguard first starting an index fund to track the S&P500 in 1975, it is renowned for its relative safety and history of success.

Hopefully, this gives you a brief idea of why people use Vanguard. A more in-depth summary of index funds and investment trusts will be provided come the new year, so watch out for that!