Investment Funds Explained: Index Funds vs Managed Funds

The short version

A fund pools money from thousands of investors and uses it to buy a large collection of investments, such as shares in hundreds of companies. Buying into a fund gives you a small slice of the whole collection, so one purchase spreads your money widely. This is how most people invest for the long term.

You get: A slice of a big pot of many investments
Typical costs: Yearly fund charge (about 0.05% to 1%+), plus platform fees
Can you lose more than you put in?: No
Risk: Medium

An index fund simply copies a market index, such as the 100 biggest UK companies or the 500 largest US companies. It’s cheap and needs no star manager.
An actively managed fund has a manager who picks investments, trying to beat the market. It costs more, and most fail to beat their index over long periods after fees.
The yearly fee looks tiny but compounds. Over 30 years, a 1% fee can eat roughly a quarter of your final pot compared with a 0.1% fee.
Funds hold shares, bonds or a mix. A fund is only as risky as what it holds.

What is a fund?

Imagine 10,000 people each putting £1,000 into a shared pot. With £10 million, the pot can buy shares in hundreds of companies, which no single person could do with £1,000. Each person owns a slice of the pot in proportion to what they put in. That’s a fund.

Funds have different names depending on where you live and how they’re built. In the US they’re usually called mutual funds. In the UK you’ll see unit trusts and OEICs (open-ended investment companies), which work in a similar way, and investment trusts, which are companies listed on the stock exchange that invest in other companies. In the EU, most funds sold to the public follow the UCITS rules. Australians say managed funds. The idea is the same: pooled money, spread widely.

An ETF is a fund that trades on the stock exchange like a share. It’s popular enough to get its own guide.

Index funds versus managed funds

A market index is a list of companies used to measure how a market is doing, such as the FTSE 100 (the 100 largest companies on the London Stock Exchange) or the S&P 500 (about 500 large US companies). When the news says “the market rose 1% today”, it usually means an index rose 1%.

An index fund (also called a tracker fund) buys the companies in an index in the same proportions, so it rises and falls with that market. No one has to decide which companies to pick, which keeps costs low.

An actively managed fund pays a manager and a team of analysts to choose investments. They aim to beat the market, but they charge more for trying, and over long periods most active funds fall behind a cheap index fund once their fees are taken off. Some do beat the market; the hard part is knowing which ones in advance.

What it costs

Ongoing charge (UK and EU name) or expense ratio (US name): the yearly fee for running the fund, taken from the fund’s value so you never see a bill. Broad index funds can charge under 0.1%; active funds often charge 0.5% to 1% or more.
Platform fee: what your investment platform charges to hold the fund, either a percentage or a flat fee.
Entry or exit charges: rare on modern platforms but still found on some funds, especially those sold through salespeople. Avoid them where you can.
Transaction costs: the fund’s own costs of buying and selling. These are listed in the fund’s documents.

Every fund has to publish a short document with its costs and risks, such as a key information document in the UK and EU or a prospectus summary in the US. Read the costs section before you buy.

The risks

Market risk. A fund full of shares falls when share markets fall. A global share fund can still drop by a third in a crash.
Concentration. A fund that holds only one country, one industry (such as technology) or one theme is much less diversified than its name suggests.
Paying for nothing. Higher fees don’t buy better results. Check whether an active fund has actually beaten its index over 5 to 10 years after fees.
Currency risk. A fund holding overseas companies rises and falls with exchange rates as well as share prices.

Rules where you live

Products, protections and tax rules differ from country to country. Here’s a summary for the main English-speaking markets. Always check your own regulator for the latest position.

UK: Funds can go in a Stocks and Shares ISA (tax-free) or a SIPP (pension)². Fund managers and platforms must be FCA-authorised, and the FSCS can cover up to £85,000 if a firm fails and your investments are missing³.
US: Mutual funds are registered with the SEC. In ordinary taxable accounts, mutual funds can pass taxable capital gains on to you even if you didn’t sell, which is one reason many US investors hold index funds or ETFs inside IRAs and 401(k) plans.
EU: UCITS funds must meet EU rules on diversification and publish a key information document. Tax on funds varies a lot by country, so check your national rules.
Australia: Managed funds are regulated by ASIC, and every fund must publish a product disclosure statement (PDS). Many Australians already hold managed funds through their superannuation (workplace pension).
Canada: Mutual funds can go in a TFSA or RRSP. Fees are shown as the MER (management expense ratio), and they have traditionally been higher than in the US, so compare them carefully.

Who it tends to suit

Tends to suit

Almost any beginner investing for five years or more.
People who want to invest regularly without picking companies.
Anyone who wants wide diversification for a small amount of money.

Think twice if

Short-term money you might need soon.
People hoping for fast, dramatic gains. A broad fund rises roughly in line with the market and no faster.

How to get started safely

Choose the account first (for example an ISA, IRA, TFSA or super), then a platform that offers it.
Decide your mix. A fund holding shares from around the world is a common starting point; adding bonds makes the ride smoother but usually lowers long-term growth.
Compare the yearly charge. For a broad index fund, look for well under 0.3%.
Set up a regular monthly investment, even a small one.
Check in once or twice a year, not every day.

Words in this guide

Fund: A pot of money from many investors, invested in a spread of assets by a fund manager.
Market index: A list of companies used to measure a market’s performance, such as the FTSE 100 or S&P 500.
Index (tracker) fund: A fund that copies an index rather than picking investments.
Actively managed fund: A fund whose manager chooses investments, aiming to beat the market.
Ongoing charge / expense ratio: The yearly fee for running a fund, shown as a percentage of your investment.
Mutual fund, unit trust, OEIC, UCITS: Different names and legal structures for pooled funds in different countries.
Investment trust: A UK company listed on the stock exchange whose business is investing in other companies.

Frequently asked questions

Are index funds safe?

They’re a sensible, low-cost way to invest, but not safe in the sense of guaranteed. An index fund falls when its market falls. What it removes is the risk of one company or one manager getting it badly wrong.

What is the difference between a fund and an ETF?

An ETF is a type of fund that trades on the stock exchange during the day, like a share. Traditional funds are usually bought and sold once a day at a single price. Costs and contents can be very similar.

How many funds do I need?

Often just one or two. A single global index fund already holds thousands of companies. Owning lots of funds that hold the same big companies adds complexity without adding much diversification.

Sources and further reading

Numbers in the guide, like ¹, point to these sources. Rules, fees and tax change, so check the latest version before you act.

Investor Bulletin: How Fees and Expenses Affect Your Investment Portfolio. Investor.gov (SEC).
Individual Savings Accounts (ISAs) GOV.UK.
Investments: what we cover. Financial Services Compensation Scheme (FSCS).

What to read next

What Is an ETF? Exchange-Traded Funds Explained: A fund you buy and sell on the stock exchange, just like a share.
Robo-Advisers and Ready-Made Portfolios Explained: Answer a few questions and a provider invests and rebalances a mix of funds for you.
Stocks and Shares Explained for Beginners: Buy a small piece of a company and share in its growth and profits.
What Are Bonds? A Beginner’s Guide to Bond Investing: Lend money to a government or company in return for regular interest.
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