Index funds explained

What is an index fund?#

The SEC defines an index fund as a type of mutual fund or exchange-traded fund that seeks to track the returns of a market index ^[1]. A market index is a basket of securities meant to represent a market or part of one, such as the S&P 500 ^[1]. If you are not sure what an index is, start with what is a stock index.

The fund exists because you cannot invest directly in an index. Index funds give you an indirect way to do it ^[1]. You own shares of the fund; the fund owns the stocks.

The goal is different from most other funds. An actively managed fund tries to beat a benchmark by choosing what to buy and sell. An index fund only tries to match its index. FINRA puts it this way: passive funds seek to replicate the performance of their benchmarks instead of outperforming them ^[2].

How does an index fund track its index?#

The simplest way is to buy every stock in the index in the same proportions as the index. When the index adds or removes a company, a fund that copies it has to trade to keep up. Between those changes there is little to do, which is the point: the SEC describes the passive approach as aiming to maximize returns over the long run by not buying and selling securities very often ^[1].

Some funds do not hold every stock. The SEC notes that a fund may invest in only a sampling of the securities in the index, in which case its performance may be less likely to match the index ^[1].

Why do index funds often cost less?#

Mostly because nobody is paid to pick stocks. The SEC explains that managers of an index fund are not actively picking securities, so they do not need the services of research analysts, and that the passive strategy may let them save costs ^[1]. FINRA says index funds normally have lower operating costs than actively managed funds ^[2].

The words "may" and "normally" matter. The SEC adds a direct warning: not all index funds have lower costs than actively managed funds ^[1]. FINRA notes that fees vary from index fund to index fund, so returns vary as well ^[2]. Two funds tracking the same index can charge different amounts. The number to compare is the expense ratio, the percentage of a fund's average net assets used each year to pay its operating expenses ^[5].

You never receive a bill for it. When fees are paid out of fund assets, the value of the fund decreases and the value of all investors' shares decreases ^[4].

How much does a small fee difference cost over time?#

More than it looks. The SEC shows a hypothetical $100,000 investment growing 4% a year for 20 years under three annual fees. The results below are the SEC's rounded figures ^[6].

SEC hypothetical: $100,000 growing 4% a year before fees ^[6]. The 4% is an assumption, not a forecast.

Why does an index fund trail its index?#

An index is a calculation with no costs. A fund is a real portfolio that pays to run and to trade. The SEC lists three reasons an index fund may underperform its index: fees and expenses, trading costs and tracking error ^[1]. Tracking error is the gap that opens when a fund does not perfectly track its index, for example because it holds only a sample of the index stocks ^[1].

This means the index return you see quoted in the news is a benchmark, not a return any fund promises you. A fund that tracks well lands close to it, usually a little below because of its costs ^[1]. A fund that trails its index by much more than its expense ratio deserves a closer look at its shareholder reports.

1. Find the index

   The prospectus names the index the fund tracks. Check what is in it before anything else.

2. Compare the expense ratio

   Look it up in the standardized fee table that every mutual fund and ETF must include in its prospectus ^[4].

3. Compare fund return with index return

   Use the same periods for both. The gap is roughly what costs and tracking error took.

4. Add trading costs

   For an ETF, add any brokerage commission and the bid-ask spread you pay when you buy and sell ^[7].

What risks does an index fund still carry?#

All the risks of the stocks it holds. In the SEC's words, like any investment, index funds involve risk, and an index fund will be subject to the same general risks as the securities in the index it tracks ^[1]. If the index falls sharply, a fund tracking it falls by roughly as much.

An index fund also cannot get out of the way. The SEC points to a lack of flexibility: an index fund may have less flexibility than a non-index fund to react to price declines in the securities in its index ^[1].

Owning several funds does not automatically spread risk either. FINRA warns that simply holding only funds does not shield you from concentration risk, because funds can hold the same companies ^[8]. Read diversification explained before you build a portfolio out of funds.

Do index funds beat actively managed funds?#

Not by design. An index fund aims to match its index, minus costs. The comparison that matters is with the active funds that try to beat that index. FINRA states that in any given year, most actively managed funds do not beat the market, and that their returns are reduced by the cost of a professional manager and of buying and selling investments ^[2].

That is a statement about averages, not a guarantee about any fund or any year. An index fund is not built to beat its index, and in a falling market it will fall with it. What it offers is a predictable relationship with the index at a cost you can check in advance.

Mistakes beginners make with index funds#

• Assuming every index fund is cheap

  The SEC says not all index funds have lower costs than actively managed funds ^[1]. Check the expense ratio of each fund, even when two funds track the same index.

• Believing an index fund cannot fall much

  It carries the same general risks as the stocks in its index ^[1]. A broad fund is still a stock fund.

• Ignoring what the index holds

  Two funds with "index" in the name can track very different baskets. Read the prospectus and the fund's holdings ^[9].

• Buying several funds that own the same stocks

  More funds is not more diversification if they overlap. FINRA lists fund overlap as a source of concentration risk ^[8].

Frequently asked questions#

The bottom line#

An index fund is a simple promise: follow an index, keep costs down and accept the index's ups and downs. Check which index a fund tracks, compare expense ratios between funds that track the same thing, and expect the fund to trail its index by roughly its costs. It removes the risk of a manager picking badly, not the risk of the market falling. Only invest money you will not need soon, and read the fund's prospectus before you buy.

Education only. This page is not investment, tax or legal advice. Stocks can lose value. See our risk disclosure.