Investing in index funds: What is it and how do you do it?

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Do you want to build wealth for the long term without being tied to the stock market every free minute? Then investing in index funds might be for you. In this article, we explain how you can let your money work for you with index funds. You will discover how it works, what to look out for, and how you can start yourself.

Index funds: meaning in short
Investing in index funds is a passive strategy where you follow a basket of investment products from an index. This offers automatic diversification across sectors or regions at low costs. Although you do not beat the market and face market risk, its simplicity and diversification make it a popular method for long-term wealth building.

What is an index fund?

An index fund is an investment fund that passively copies the return of a specific market index. These can be stocks, but also bonds, currencies, or commodities. Instead of selecting individual stocks, the fund buys all securities within that specific index. This can be a country, but also a region, sector, or theme. This ensures automatic diversification and lower management costs than with active funds, which can lead to a higher net return for the investor in the long term.

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What is index investing?

Index investing is a passive investment strategy (tracker) where you invest in a basket of stocks or other financial instruments from different companies within one group: the index (or indices). You can see it as a basket with different types of fruit like apples, bananas, and strawberries. This ensures good diversification of your investments without buying individual stocks, thereby spreading the risk.

How does an index fund work?

An index fund is compiled by an index provider and follows a specific market index instead of trying to beat it. The fund manager pools the capital of investors to then invest it in a ‘basket’ of investment products that mimic the index. When the composition of the specific market index changes, the fund adjusts this automatically. As a result, the return on your investment moves with the market.

What are the advantages of investing in index funds?

Why would you choose index funds? Below you will find a number of reasons:

• Lower costs: Because no active fund managers are needed when investing in index funds, the management costs are low. This means you can keep more of your return.
• Broad diversification: You invest in hundreds or thousands of companies simultaneously, which reduces the risk compared to investing in a single stock.
• Simplicity: You do not have to be a financial expert or understand complex products to start. It is not necessary to analyse individual stocks, which makes it attractive for beginner investors.
• Higher return: In the long term, an index fund can show a positive return.

What are the disadvantages of investing in index funds?

Index funds also have a few points of attention:

• Never beat the market: With an index fund, you cannot beat the market because you always follow the index. Your return is the market average, minus the small costs.
• Market risk: If the broader market goes down, your fund drops with it. There is therefore always a risk of loss.
• No choice: You also have less control over the content; if you do not want to invest in a company in the index, you cannot exclude it within that fund.

Different types of index funds

There are hundreds of different indices worldwide. For example, by country, region, sector, or theme. You can choose an index that reflects the global stock market or an index in emerging markets. Additionally, sustainable index investing is on the rise. You can also focus on specific regions, such as the US stock market, or specific types like mid-sized companies.

From the Dow Jones Industrial Average to the AEX index: Well-known indices

• AEX: As the most important Dutch stock index, the Amsterdam Exchange Index follows the 30 largest listed companies on the Amsterdam stock exchange.
• Dow Jones: This is the oldest and best-known American index, consisting of thirty large listed companies on the NYSE and the Nasdaq.
• Nasdaq Composite Index: This fully digital American exchange is known worldwide for trading stocks of mainly technology companies.
• S&P 500: The S&P 500 provides a reliable picture of the US economy by following the performance of the 500 largest listed companies in the US.
• MSCI World: Morgan Stanley Capital International covers approximately 85% of global listed companies by following stocks from 23 developed countries.

Passive index funds vs actively managed investment funds

In the investment world, you have two types of funds: index funds and investment funds.

• Index funds: Index funds follow the index instead of beating it. The investments are only adjusted if the composition of the index changes. It is a way of passive investing. Because you pay less for management, more return remains for you at the end of the day.
• Investment funds: With investment funds, a wealth manager actively tries to outsmart the market by buying or selling the best investment products at the right time. The goal is to achieve a better return than the index. Since the fund is actively managed, you have to pay more for it.

What is the difference between index funds and ETFs (Exchange Traded Funds)?

Both index investment funds and ETFs are index funds that follow an index. Yet there is a difference between both forms of investing.

The difference between an index fund and ETF

How risky are index funds?

Investing is never without risk with any investment product. With index funds, the risk lies mainly in market movement because it follows an index. Some funds are more volatile than others.

Still, an index fund can be a strategy to diversify your portfolio for the long term. After all, you invest in a basket of different companies. The more time you have, the smaller the impact of temporary dips. Please note: past performance is no guarantee of future results.

Comparing index funds: What should you look out for?

When comparing index funds, it is wise to pay attention to a number of points:

1. Type of index: There are many different indices. It is good to look at the degree of diversification and the way the index is compiled. The Amsterdam Small Cap Index follows only a small part, while a broad, global index contains diverse companies. Ensure the index fits the risk you want to take.
   
   
2. Investment policy: An index fund can follow an index in various ways: full replication, partial replication, or synthetic replication.
   
   
   • Full replication: The fund buys all stocks from the index in exactly the same ratio to copy the performance one-on-one.
   • Partial replication: The fund buys a representative selection of the stocks in which the index invests.
   • Synthetic replication: Instead of owning the physical stocks, the fund uses derivative products.
3. Costs: Various costs are involved with an index fund. You pay both annual fund costs (the Total Expense Ratio (TER)) to the fund manager and transaction costs to the bank or broker.
   
   
4. Dividend tax: Index funds that follow stocks pay out dividends to investors. Upon issuance, a part is withheld: the dividend tax. In the tax return, you cannot reclaim part of that, which is known as dividend leakage. This can lead to a lower return. How much is withheld in terms of dividend tax differs per index.
   
   
5. Stock lending: Some fund managers lend the stocks in the fund to other investors to generate extra income that can increase the fund’s return. However, this brings extra risk.

How can I invest in index funds?

You can invest in an index fund at a bank or broker, such as BUX. But before you deposit your first euro, it is wise to have three things clear:

• Goals: What are you investing for? Retirement? A house? Studies for the children?
• Investment horizon: How long can you do without the money?
• Risk appetite: How much fluctuation can you handle?

Once you have these points clear, you can open an investment account and build your portfolio.

Index investing at BUX

You can easily start index investing via a broker, such as BUX. With us, you can invest in ETFs, allowing you to choose from various options that fit your goals.

Want to make it even easier? Then choose the BUX Investment Plan. On our user-friendly platform, the BUX app, you can set up your investment plan in a few steps. Choose the amount you want to deposit every month, starting from just €10, and select the ETFs that suit you. We ensure your deposit is automatically invested. All you have to do is choose a day of the month and determine your goal. This way, you work simply and structured on your return.

Read more about Dollar Cost Averaging (DCA).

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Investing involves risks. You can lose your investment.

All views, opinions, and analyses in this article should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.