What is an index fund?

What are index funds?

An index fund is a type of investment that mirrors the performance of a particular index - a group of companies or assets that represent a segment of the market.

For example:

• The FTSE 100 tracks the 100 largest UK-listed companies.
• The S&P 500 tracks 500 leading US companies.

When you invest in an index fund, you’re essentially buying a tiny share in all the companies within that index. The value of your investment rises or falls depending on how all of those companies perform overall.

Because your money is spread across many businesses, index funds are usually less risky than investing in a single stock. You can further diversify by investing in multiple index funds that track different markets or sectors.

Learn more: How to start investing

How do index funds work?

Index funds are known as passive investments because they don’t rely on fund managers making daily decisions about which shares to buy or sell. Instead, they automatically track an index. For example, if a company enters or leaves the FTSE 100, your fund will adjust to reflect that change. This approach keeps costs lower than actively managed funds, where managers are paid to try to outperform the market.

Advantages of index funds:

• Lower fees – as the stocks included in a particular index rarely change, resulting in lower trading costs and fees
• Diversification – spreads your risk across dozens or hundreds of companies, usually for less than if you were to purchase all the stocks in the index individually
• Simplicity – they track the market, so you don’t need to choose individual stocks.

Disadvantages of index funds:

• Less flexibility – you can’t remove specific underperforming companies or those you’d prefer to not invest in
• No guaranteed returns – although index funds are typically lower risk than individual stocks, markets can still fall and you could get back less than you put in.

When you invest in the stock market, the value of your investments can go down as well as up, and you may get back less than you put in. You can reduce the risk by investing for the long term, as this gives your investments time to weather any downturns in the market. If you’ll need to access your money sooner, consider saving in a Cash ISA or standard savings account instead. 

Do index funds pay dividends?

Yes, many index funds pay dividends. When companies within the index pay dividends to shareholders, those payments are passed on to investors in the fund. You can either:

• Take them as income (known as distributing, or “Dist”), or
• Automatically reinvest them to buy more shares (accumulating, or “Acc”).

Reinvesting dividends can accelerate your portfolio growth over time, thanks to compound returns.

The frequency of dividend payments varies. Some index funds pay quarterly, others biannually or annually. Always check the fund’s documentation to see how and when dividends are distributed.

Learn more: Do I need a financial advisor?

What’s the difference between ETFs and index funds?

Both index funds and exchange-traded funds (ETFs) track the performance of a market index, but they trade differently.

• Index funds are bought and sold at a set price once per day.
• ETFs can be traded throughout the day like individual shares, so their prices fluctuate based on market demand.

In short: ETFs offer more flexibility for frequent traders, while traditional index funds are ideal for long-term investors who prefer a “set and forget” approach.

Are mutual funds index funds?

An index fund can be a type of mutual fund, but not always. A mutual fund is a fund that pools money from lots of investors to buy a portfolio of securities designed to meet a particular goal, while an index tracks a market index, like the top 100 companies listed on the UK stock market. Mutual funds are usually actively managed, meaning a fund manager selects which stocks to buy and which to avoid. 

What is the best index fund in the UK?

There isn’t a single “best” index fund. The best index fund in the UK for you all depends on your goals, risk tolerance and time horizon.

Some of the most popular index funds include:

• FTSE 100 Index Funds – invest in the largest UK companies.
• S&P 500 Index Funds – focus on major US firms like Apple, Amazon and Microsoft.
• Global All Cap Funds – offer exposure to thousands of companies worldwide.

But you don’t have to go for these indexes. When shopping around, look for low fees, consistent tracking performance and a provider with a strong reputation.

Are index funds a good investment?

For many people, yes. Index funds tend to perform well over the long term because they mirror the broader market rather than betting on individual stocks. They also avoid the higher costs that can eat into the returns of actively managed funds.

However, although index funds tend to be less volatile and lower risk than individual stocks, you’ll still experience market dips, particularly in the early days, when your investments haven’t had much time to grow. 

If you’re investing for the short term or you need to sell your investments in an emergency, you could get back less than you put in. 

If, however, you’re investing for the long term, say for 10 years or more, you’ll usually find that your index fund investments will far outperform cash savings and inflation. This is why it’s so important to stay calm and keep your money invested through the ups and downs.

Which index fund is best for beginners?

If you’re new to investing, look for broad, low-cost index funds that track major markets such as:

• The FTSE All-World Index (global exposure).
• The FTSE 100 (UK focus).
• The S&P 500 (US focus).

A global index fund can be a good all-rounder for beginners because it automatically spreads your money across different countries and industries. 

How long should I keep money in an index fund?

Index funds are designed for long-term investing, ideally five years or more. The stock market can fluctuate daily, but staying invested gives your portfolio time to recover from short-term dips and benefit from compounding growth.

If you think you’ll need your money within the next couple of years, a Cash ISA or savings account might be more suitable. But if you’re saving for the long term, for example, for retirement, an index fund could offer stronger returns.

How to invest in index funds

1. Compare investment platforms

Start by comparing investment platforms and providers. Most investment platforms will charge a fee for certain services, such as fund management fees, account fees, and trading costs, but there are newer providers that may offer free options.

The fees may seem small, but the costs can add up over time. It’s important to research different options to see which best fits your needs and budget.

2. Choose an account type

Some providers will offer a choice of account type. For example, you could invest in index funds within a general investment account (GIA), but you may need to pay tax on your profits. 

If you choose a Stocks & Shares ISA, you won’t pay any income tax or capital gains tax on your investment growth. You can invest up to £20,000 a year in a Stocks & Shares ISA or spread this allowance across multiple ISA types, including Cash ISAs and Lifetime ISAs, which are also tax-efficient.

Learn more: Best Cash ISAs in the UK.

If you’re saving for your first home or retirement, a Lifetime ISA can be really rewarding. You can only save or invest £4,000 of your total ISA allowance in a LISA each year, but the government will boost your contributions by 25%. So, max out your LISA before the end of the tax year, and you’ll get a £1,000 bonus.

Keep in mind that if you withdraw from your Lifetime ISA before age 60 for something other than an eligible first home, you’ll pay a 25% charge. Take a look at our guide to the Lifetime ISA withdrawal penalty to learn more about how this works. 

Learn more: The Lifetime ISA and the tax year. What you need to know

3. Open an account

Many providers let you open an account online or by downloading their app. If you already have a Cash ISA or Stocks and Shares ISA, you may be able to transfer your savings or investments to a new ISA provider. Not all ISA providers will allow transfers in, but they can’t stop you from transferring out. So if transferring an existing ISA is important to you, make sure you choose a provider that welcomes transfers. 

4. Choose your fund and invest

Once your account is open, select the index fund you want to invest in and decide whether to invest a lump sum or set up regular monthly payments. Investing little and often, known as cost averaging, helps smooth out market fluctuations over time.

*Based on saving £100 at the beginning of each month for 5-years. Calculations show at month 61 (after 5-years) Tembo customers saving at 3.80% would have £390.68 on average more than saving with Barclays, HSBC, NatWest or Lloyds. Accurate December 2025.