Index funds can be a great way to invest, but not all index funds are as similar as they first appear.
Index funds have become popular with investors looking for a simple way to invest. They're low cost, easy to understand and can be a great starting point for building a portfolio.
Though they're often seen as straightforward investments, it's still important to look under the bonnet and make sure they're investing in the areas you want them to.
So, we’re breaking down some of the most common myths about index investing and explaining the reality.
This article isn’t personal advice. If you're not sure what is right for you, ask for financial advice.
Myth: All index funds are the same
The reality – even index funds investing in the same market can look very different.
It's easy to assume that two funds investing in the same market will hold similar investments and deliver similar results. But that's not always the case.
Much depends on the benchmark they track.
Some indices aim to represent an entire market and can contain hundreds or even thousands of investments. Others focus on specific parts of the market instead.
Myth: Index funds automatically provide perfect diversification
The reality? – the amount of diversification depends on the index.
Index funds are often associated with diversification, but some spread investments much more widely than others.
Some invest in hundreds of companies across multiple countries and sectors. Others can be very concentrated, with a large proportion invested in certain regions, industries or even a handful of companies.
For example, many global indices currently have significant exposure to large US tech companies. While these companies have performed well in recent years, it means performance is more reliant on the fortunes of a relatively small group of businesses than you might expect. Past performance is not a guide to the future.
Myth: All index funds follow the same approach
Reality – indices can be built in many different ways.
Many well-known indices give larger companies a bigger share of the index than smaller ones.
But this isn’t the only approach.
Some indices give every company an equal share of the index, regardless of size. Others exclude specific countries or sectors. There are also thematic indices that focus on particular investment themes, like artificial intelligence (AI), clean energy or cybersecurity.
Myth: A fund's name tells you everything you need to know
Reality – the name is only the starting point.
Fund names can be useful, but they rarely tell the whole story.
Different index providers can categorise regions in different ways, and sector definitions can vary too.
For example, not all Asia Pacific ex Japan index funds include China and India. Some track indices that focus only on developed markets, excluding emerging markets like China and India.
Myth: The cheapest index fund is always best
Reality – cost matters, but it shouldn’t be the starting point.
One of the biggest attractions of index funds is their low cost. Lower costs mean less of a drag on returns, making it easier for a fund to stay in line with the index it tracks.
However, investors should first decide what they want from a fund.
For example, one global index fund might invest in thousands of companies around the world, while another could hold fewer investments or leave out certain markets. Investors might be happy to pay a little more for a fund that better matches what they're looking for.
What does this mean for investors?
Index funds are often simple, low cost and offer broad market exposure.
But index investing doesn't mean investors should switch off completely. It's important to look beyond the fund name and understand what's actually inside the fund.
Taking the time to do that can help avoid surprises and make sure an index fund meets your expectations.
Investing can help your money grow, but the value of investments can rise and fall, so you could get back less than you put in. Investing is for the long term, typically 5 years or more.
If you’re not sure whether investing is right for you, a financial adviser can help.