Explained: How do index funds work?

Let's say that you wanted to buy shares in all of the companies listed on the stock exchange. How would you do it?

If you had to buy them one by one, you would pay brokerage fees for each investment and you would need a huge portfolio to be able to pay for them all...like...seriously BIG!

Fortunately, you can buy into an index fund which does it for you.

How do they work?

Index funds are investment funds that are managed by a finance company to follow an index, like the ASX 200, which includes 200 companies, or the Dow Jones, which includes 30 companies.

When you buy into the fund, you get exposure to all of the shares included in the index.

For example, if you invested $500, the fund manager would go and buy each share in the index after pooling your money with other investors in the fund.

How can I buy an index fund?

Some index funds are listed on the sharemarket as an Exchange Traded Fund (ETF), so they can be bought and sold like a normal share using your share broking account. Many other index funds require you to apply directly to the fund manager, which requires you to fill out paperwork.

Are all ETFs Index Funds?

No. Even though the terms are used interchangeably they are not the same thing.

An 'ETF' is like the candy bar wrapper around a managed fund. What's inside is the managed fund (which could be an index fund, bond fund, property, chocolate, etc.). It's strategy is what you should focus on.

Do index funds have risks?

It's important to remember that index funds have risks, and the performance will vary depending on which index your fund tracks. As always, you should carefully read the product disclosure statement (PDS), which must be issued by a company which runs an index fund.

It's a couple minutes of reading that could save you thousands.

And if you get confused, we're always here to answer your questions.

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