What are index funds?

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Investing in index funds is often considered an easier, lower-risk way to get into the stock market without having to research and choose individual stocks or bonds yourself. Index-tracking ETFs, in particular, have become a popular choice among new investors in Ireland.

But what are index funds, exactly, and what are the pros and cons? In this guide, we’ll look at how they work and what to consider if you’re thinking of investing in index funds.

Index funds are a type of investment fund designed to match the performance of a stock market index. You might have already come across mutual funds or exchange-traded funds (ETFs): both of these use this index-tracking investment strategy that aims to match an index’s performance.

A definition of index funds wouldn’t be complete without understanding what an index is. An index can be described as a snapshot of how a group of stocks or bonds is performing. For example, the FTSE 100 is a type of index that tracks the 100 largest companies in the UK, while the S&P 500 covers 500 major US companies.

By pooling your money into an index fund, you get the benefit of instant diversification, since you’re investing in a broad range of assets all at once. That’s why index funds are often considered a cheaper and more effective way to build a balanced investment portfolio.

When you invest in an index fund, your money joins with funds from other investors to create a large pool. A manager then uses this pool to buy the same basket of assets, in the same proportions, as those in the specific index.

Index funds are “passive” investments, because they aim to match—not beat—the performance of the index. This approach usually keeps costs low, because the fund buys and sells assets less frequently, only making changes when the index itself changes, such as when companies are added or removed.

In Ireland, index funds often track major indexes such as the FTSE 100, but you can also find ones focused on specific sectors, regions, or company sizes.

Investors can buy and sell shares in an index fund quite easily. This is because they are “open-ended”, which means there isn’t a fixed number of shares available. Instead, new shares are created when more people invest, and existing shares are redeemed when investors decide to cash out.

The price of these shares is determined by the fund’s net asset value (NAV), which is calculated at the end of each trading day. The NAV is simply the total value of the fund’s assets, minus any liabilities, divided by the number of shares. This way, the price you pay or receive for the shares reflects the current market value of the fund’s investments.

There are two main ways to invest in index funds: through mutual funds or ETFs. Mutual funds are priced and traded only once a day, after the market closes, based on the NAV. ETFs, on the other hand, trade on stock exchanges throughout the day, so their prices fluctuate during market hours. As such, you can buy or sell shares at various prices, potentially getting a cheaper deal.

Index funds tend to pay out dividends based on the performance of the companies that the funds track. They pay out investors in two main ways:

Cash dividends: Some companies that the index fund invests in pay out a portion of their earnings to shareholders. When this happens, these dividends are also paid out to investors. In some cases, this is known as “income” from an index fund, meaning you receive payouts at regular intervals. The money is usually transferred directly into your brokerage account as cash.

Reinvested dividends: Instead of taking the dividend as cash, you can choose to reinvest it. This means the fund will use the dividend money to buy more shares of the index fund on your behalf. This can help your investment grow over time.

Yes, index funds are widely considered suitable for beginners. Not having to constantly monitor the markets or choose individual stocks can take the effort out of investing. You get the benefit of automatic diversification, meaning your money is spread across many different stocks or bonds, which can help reduce risk.

Index funds are also attractive to beginners because they generally have lower fees than actively managed funds. Plus, you don’t need a great deal of investing knowledge to get started.

However, it’s still important to do your research so that you understand both the advantages and potential downsides before you invest in index funds.

An index fund tends to offer a better return for your money than actively managed funds over the long term, thanks to their lower fees. It’s also a transparent form of investing, as anyone can see how a particular index is performing. However, there are a few drawbacks to keep in mind.

One of the main disadvantages is the lack of flexibility. Because index funds are tied to a specific market index, they can’t adjust if the market takes a downturn. If the market falls, the value of your investment falls too.

Another issue is that index funds don’t offer downside protection—there’s no limit to how much you can lose if the market falls. Plus, you don’t have a say in which stocks or bonds are included in the fund; you’re simply investing in whatever the index contains. And because index funds are designed to track the market rather than beat it, they won’t deliver returns that exceed the market’s performance.

Yes, index funds do have fees, but they’re usually lower than those of other investment funds. This is because the fund manager’s job is that much easier: replicating the performance of an index is more straightforward than selecting and monitoring the performance of individual stocks or bonds. With index funds, your investment is essentially on autopilot.

The main fee to be aware of is the expense ratio. This is the percentage of your investment that goes to cover the fund’s management and administrative costs. For example, Vanguard’s index funds have expense ratios between 0.08% and 0.27% as of August 2024. If you invest through a third-party provider like Standard Life, the total fee might be higher, around 0.95%, because it includes both Vanguard’s fee and the provider’s additional charges.

When it comes to holding index funds, investors are usually in it for the long run. Experts often recommend investing for a period of up to 10 years. Because they can be quite volatile in the short term, by holding onto your investment for longer, you can weather those ups and downs and potentially improve your chances of seeing positive returns.

It can also help to look at previous performance. Different index funds track different markets, and their performance can vary over time. Checking the fund’s prior long-term performance can give you an idea of how it might do in the future. However, past performance is never a guarantee of future results, and there’s always a risk of losing your initial investment. Investing is never without risk

Another consideration for residents of Ireland in particular is the tax rules on investing.

Every eight years, investments are subject to a “deemed disposal”. This means that, for tax purposes, you are considered to have sold your investment and must pay Capital Gains Tax (CGT) on any gains made up to that point. The CGT rate in Ireland is currently 33%.

With index funds, the “exit tax” also applies. This tax is levied at 41% on any gains when you actually sell your investment.

The combination of taxes can make investing in index funds less attractive to some investors in Ireland. If the market declines after you’ve paid tax on the gains, you could end up with a loss, but still face tax liability on the previously realised gains.

If you’re uncomfortable with the risks or taxes associated with investing in an index fund in Ireland, you might want to consider high-interest savings accounts instead. Options like fixed term deposits let you stash away your money at a guaranteed competitive interest rate for a set period. At the end of this period, you get back your initial deposit plus the interest earned.

Also, up to €100,000 of your savings is protected per bank, so your money is safe even if the bank runs into trouble. If you have more than that amount, you can easily open multiple accounts through Raisin Bank to stay within the protection limits.

If you’re looking for a hassle-free way to boost your savings, registering for a Raisin Account is quick and easy. You can access a range of competitive savings accounts from various banks, all at no cost.