Index funds investments are a great way to grow your money and build wealth. There are different types of index funds that you can invest in.
Investing in index funds is my favourite long term wealth building strategy.
Firstly, the compounding interest earned causes the value of your investments can grow over time.
This is interest on interest growing on top of your contributions to the fund.
Secondly, it’s the passive investment strategy where you can set and forget your investments.
You can sleep fine at night, enjoy social events, and watch movies knowing that your investments are automated and growing.
In addition, there is no requirement for you to read through company reports, research into the strategy and analyse financial statements.
Investing in an index fund instantly gives you a diversified portfolio of shares in a huge number of companies.
Those are just two reasons to invest in index funds, there are so many more.
How do Index Funds Work
An index fund is an investment that tracks an index.
An index is a measurement of something, in the world of investing an index measures the performance of shares, bonds, commodities etc.
In the UK we have the FTSE 100, which are the largest 100 UK companies such as Barclays, BP and Tesco.
In the US there is the S&P 500, which are the largest 500 US companies such as Amazon, Facebook and Apple.
A FTSE 100 Index fund would track the FTSE 100 index and follow its performance. If the combined average performance of these 100 companies goes up, so does the index fund.
All index funds track the performance of their chosen indexes. There are numerous indexes that exist with a wide range of companies therefore we are looking at 5 types of index funds.
5 Index Funds Types to Know About
Broad Market Index Funds
Broad market index funds aim to match and track an index that holds a broad number of shares, bonds, or other investment classes.
These offer the most diversified fund as the number of companies held in one fund can be in the 000’s.
For instance, the Vanguard Total Stock Market Index Fund (VTSAX) holds 3500 shares within it. Allocations are around 26% technology companies, 16% Financial companies, and 15% healthcare companies.
Also, the Vanguard Total Bond Market ETF (BND) holds 8800 bonds in the fund.
When you invest in bonds you are lending money to companies / governments for a set period and generating income for yourself through fixed rate of interest. By the time the bond reaches maturity, your original investment should be repaid in full plus the interest.
The broad market index fund holds shares and bonds of all sizes from the largest ones to the smallest ones. In other words this gives you the broadest investment portfolio in one fund.
Market Capitalization Index Funds
Market capitalization, popularly termed market cap, is the total value of ALL the shares of a company. You calculate this by multiplying the price per share by the number of outstanding shares.
For example, a company with 20 million shares at £50 per share has a market cap of £1 billion.
Market cap is used to measure the size of a company alongside how much it’s worth on the open market. Moreover, it indicates the perceived value of the company based on what investors are willing to pay for the share.
Market cap weightings:
- Large companies have a market cap of $10 billion or more
- Medium companies have a market cap between $2 billion and $10 billion
- Small companies have a market cap of less than $2 billion
You will be able to find index funds that track indexes based on market cap.
Index Funds by Market Cap
Large cap index funds:
- S&P 500 index funds, 500 largest US companies
- FTSE 100 index funds, 100 largest UK companies
Large cap companies generally offer steady growth, and have a history of consistent dividend payments. On the other hand, they carry less risk than mid and small cap as they usually have less aggressive growth potential.
Mid cap index funds:
- S&P MidCap 400 index funds, mid-sized US companies
- FTSE 250 index funds, mid-sized UK companies underneath the FTSE 100
Mid-cap companies fall between large caps and small caps on the risk/return spectrum. Mid-caps may offer more growth potential than large caps, whilst having less risk than small caps.
Small Cap funds:
- FTSE Small Cap index funds, around 270 small UK companies
- Russell 2000 index funds, 2000 small cap US companies
Small caps may offer significant growth potential to long-term investors who can tolerate volatile market swings in the short term. However, these carry a huge amount of risk as they are more susceptible to a business or economic downturn.
Growth Index Funds
When you invest in the shares you usually have one of 2 strategies, income and growth. Growth is when you reinvest the gains you make from the investments back into the fund to boost your portfolio amount. I’ll get into income as the next index funds type.
Growth index funds hold a collection of companies that have the potential to grow in a fast aggressive manner. Think of the next Netflix or the next Tesla. Companies that have a promising future who serve a booming market.
In these you will see your investments will go up and down in the short term due to market fluctuation. However, if you don’t mind that over potential long term growth they could be enticing.
Growth index funds:
- HSBC FTSE 250 Index Fund
- Legal & General UK Mid Cap Index Fund
Dividend Index Funds
As mentioned before, investors follow one of 2 strategies, growth and income. Income is where you receive the profits the company makes as a form of passive income.
With dividend funds they either focus on dividend growth, which are companies that increase the rates of their dividends and are likely to keep doing so. On the other hand is dividend yields, where the fund has companies that offer a high rate of dividend yield.
Dividend yield is a ratio that shows how much a company pays out in dividends each year relative to its share price. Great if you’re looking for regular passive income, however you can also reinvest the dividends back into the fund.
Dividend Index Funds:
- Vanguard’s FTSE UK Equity Income Index
- iShares UK Dividend UCITS ETF
Bond Index Funds
The above 4 types of index funds have been leaning more towards equities (shares), this type is going for the other side of bonds. As a reminder, when you invest in bonds you are actually lending money to companies / governments in return for an income.
Bonds pay out annual interest rates to investors while repaying the amount in full at some point. That’s why they are considered a safer investment compared to shares as they carry less risk.
There are 4 main types of bonds. Government bonds (aka Gilts), corporate bonds, aggregate bonds and inflation-linked bonds.
Governments use bonds to raise funds that can be spent on new projects or infrastructure, and as an investor you get a set return. Government bond index funds:
- Vanguard U.S. Government Bond Index Fund
- Vanguard U.K. Government Bond Index Fund
A corporate bond is from a company that wants to raise money and investors get in return for a series of interest payments. Corporate bond index funds:
- iShares Corporate Bond Index Fund (UK)
- S&P U.K. Investment Grade Corporate Bond Index Fund
Aggregate bond funds, also called Barclays Capital Aggregate Bond Index Funds, contain a mix of both government and corporate bonds. Agg bond index funds:
- Vanguard Global Aggregate Bond UCITS ETF (VAGP)
- iShares Corporate Bond Index Fund (UK)
Finally, Inflation-linked bonds are government bonds designed to grow your money above the rate of inflation. The principal and interest payments rise and fall with the rate of inflation. Inflation-linked bond index funds:
- Legal & General Global Inflation Linked Bond Index Fund
- iShares Global Inflation-Linked Bond Index Fund
Final Thoughts on Index Fund Types
Index funds are a great passive method of investing and should be considered as part of your portfolio. They offer a good place for your money to grow and make more money for you.
To clarify, index funds are not meant to be sexy, they’re quite boring because they follow the market. If the market is up, the index is up. If the market is down, the index is down.
But considering the market has generated between 7-8% returns on average per year, it’s the good kind of boring in my opinion.
The variations of index funds in the mix bring more variety and as a result, offer you various ways to construct your portfolio. For instance, dividend index funds could bring you more income than the a broad based index fund.
Above all, index funds enable you to diversify your portfolio in one fund containing the type of assets that you want to invest in.
Take Action
Which of these index funds types intrigue you the most?
If you’re not invested yet, get ready to start investing.
Share this with your friend, family, or partner and discuss your investing approach. Encourage them to learn about investing if they haven’t done so yet.
Download our Free Financial Health Check to give you a good overview of your financial health.
Let us know how you’re getting along by getting in touch with us, we’d love to hear from you
Knowledge is powerless without action
So take action, and take care
Thando