What is an index fund?
An index fund is an investment fund that mirrors the performance of a specific stock market index. A stock market index, such as the DAX or MSCI World, summarises the performance of selected securities, particularly shares, to represent a specific market or sector. For instance, the DAX measures the performance of the 40 largest companies in the German stock market, including Adidas, Allianz, BASF, Bayer, Deutsche Bank, Henkel, RWE, SAP, Volkswagen, and many more (as of December 2024).
What makes index funds unique is their passive nature. They aim to replicate the composition and performance of an index as closely as possible. This distinguishes them from actively managed funds, where fund managers make targeted buy and sell decisions to outperform the market.
Index funds are particularly popular because they offer investors a low-cost and straightforward way to participate in the performance of major markets. They are suitable for both beginners and experienced investors looking to diversify their portfolios without relying on complex strategies.
Index funds vs ETFs: What's the difference?
ETFs (exchange-traded funds) are a type of index fund traded on the stock exchange, making them more flexible and often cheaper than traditional index funds. Although both replicate the performance of a stock market index, they differ in trading accessibility and structure. Another key distinction lies in replication methods: ETFs typically use physical replication by directly purchasing the securities in the index, while index funds may also use synthetic or optimised replication methods.
Key differences between ETFs and index funds:
Trading: ETFs are traded on the stock exchange and are available flexibly during trading hours, while index funds are settled once daily via the fund company
Costs: ETFs often have lower ongoing fees, while index funds may include upfront and redemption charges
Replication methods: ETFs predominantly use physical replication, whereas index funds may use synthetic or optimised methods
Use case: ETFs are ideal for active investors seeking trading flexibility, while index funds are often used in long-term savings plans
Both offer distinct advantages. ETFs excel in flexibility and lower costs, while index funds are well-suited for long-term, automated investments.
How do index funds work?
Index funds operate on a replication principle: they track the performance of a stock market index like the DAX or MSCI World. Instead of being actively managed, an index fund follows a predetermined structure that automatically adjusts to match the index.
This passive strategy involves replicating an index by holding its securities, such as shares or bonds, in the same weighting. Depending on the method, the fund may directly buy the relevant securities (physical replication) or use financial instruments like derivatives to replicate the index's performance (synthetic replication).
The result is a broad diversification across all the securities in the index, allowing investors to benefit from dividends that contribute to returns. This provides balanced risk distribution and market returns without the additional costs and decisions associated with actively managed funds. The simplicity and efficiency of index funds make them an appealing option for long-term investors.
How to invest in index funds
To invest in index funds, you need a securities account, which you can open with a bank, online broker, or specialised platform. Exchange-traded index funds are purchased directly on the stock exchange via your account, while traditional index funds are available through fund providers, banks, or brokers. Savings plans are particularly convenient for regular investments, allowing you to invest small amounts in index funds automatically.
Steps to invest in index funds:
Open a securities account: Choose a bank, online broker, or platform that offers access to index funds
Select a fund: Decide which index (e.g., DAX, MSCI World) aligns with your investment goals and select the corresponding fund
Choose a purchase method: Decide whether to make a one-off investment or invest regularly through a savings plan
Make a purchase: Buy exchange-traded index funds directly on the stock exchange via your account, or purchase traditional index funds through a provider or broker
Monitor your portfolio: Keep track of your investment's performance and review regularly to ensure it aligns with your financial goals
With a securities account and the right strategy, you can invest in index funds simply and flexibly. Whether through a one-time purchase or a savings plan, on the stock exchange or directly with a provider, index funds offer versatile options.
Investment strategies for index funds
Before choosing a strategy, consider your financial goals, risk tolerance, and investment horizon:
Financial goals: Global indices like MSCI World provide diversification, while regional indices like DAX are more focused
Risk tolerance: Broadly diversified indices reduce risk, while specialised funds offer higher returns but greater volatility
Investment horizon: Longer periods smooth out market fluctuations, whereas shorter-term investments may require conservative strategies
Two main strategies:
Lump-sum investment: Ideal if you have significant starting capital, allowing you to fully benefit from market developments immediately. However, this approach is more exposed to short-term fluctuations.
Regular savings plans: Invest smaller amounts regularly, such as monthly, which is especially suitable for long-term wealth building without a large initial sum. This strategy benefits from cost averaging, as consistent payments spread investment over various price levels.
These approaches can also be combined to leverage the advantages of both and tailor investments to your goals.
For example, with the Bitpanda Savings Plan, you can automate and flexibly invest in digital assets like cryptocurrencies, stocks, and commodities. Regular contributions let you benefit from the cost-averaging effect while reducing reliance on market volatility. Bitpanda's crypto index savings plans are particularly appealing, as they waive purchase fees for efficient investments.
Costs of index funds
Index funds are known for their low costs, but investors should consider both initial and ongoing fees.
Initial costs:
Upfront charges: Traditional index funds may include a one-time charge of up to 5% of the investment
Trading fees: Passive equity index funds incur order fees, usually ranging from 0.1% to 0.3% of the transaction value
Account fees: Some providers charge for account management, though these fees are often waived by online brokers
Ongoing costs:
Management fees: The total expense ratio (TER) includes all ongoing costs, typically between 0.1% and 0.5% annually. For example, a TER of 0.3% on €1,000 would amount to €3 per year.
Tracking difference: Minor deviations between fund performance and index returns due to fees or replication methods
Rebalancing costs: Expenses incurred when adjusting the fund composition to match the index
This transparent cost structure makes index funds an affordable option for long-term investments.
How much do index funds earn?
Index fund returns directly reflect the performance of the underlying index. Since they aim to replicate the index 1:1, returns usually match average market performance minus costs and plus reinvested dividends. For example, the MSCI World Index has delivered an average annual return of about 9% since its inception in 1975, although results vary depending on market conditions and investment horizons.
Even in the cryptocurrency space, index fund-like solutions, such as crypto indices, enable investors to diversify across multiple cryptocurrencies and benefit from the overall market’s performance, much like traditional index funds.
