A stock market index is a 'basket' of companies selected according to certain rules (the largest in a country, in a sector, etc.) that acts as a thermometer of the market. An index fund is an investment vehicle that uses the money of thousands of investors to buy all the shares that make up that index in the same proportion. There is no human manager deciding what to buy: an algorithm simply replicates the index.
Two types depending on what they do with dividends:
- Distribution funds: They pay the dividends distributed by the companies directly into your current account. (This implies paying tax when they are received.)
- Accumulation funds: They automatically reinvest those dividends within the fund to buy more shares, accelerating compound interest. They are the most tax-efficient for the long term.
Advantages:
- Exact fractional investment — you can invest any exact amount you want, there is no need to buy whole units.
- Ideal for automatic DCA: you could set up a monthly transfer to automate the process.
- Instant diversification across hundreds or thousands of companies.
- Minimal fees (0.03–0.20% per year).
Disadvantages:
- Slow — a buy or sell order can take 2 to 4 business days to execute.
- You do not know the exact price you enter at until after the order has been executed.
⚠️ Important
Tax advantage of switching between funds (varies by country): In some countries — including Spain — you can move money from one fund to another without paying tax at that point. You only pay tax on the day you withdraw the money to your current account. This advantage does not exist in all countries or in ETFs.