Key takeaways
- An index fund is a mutual fund, ETF or unit investment trust that follows a passive strategy designed to achieve approximately the same return as an index, before fees.
- It does so by holding the index's securities, all of them or a representative sample, and sometimes derivatives.
- Passive management usually means less trading, lower transaction costs, fewer realised gains and lower fees than active funds.
- An index fund still falls when its index falls; it offers the market's return, including its losses, not protection from them.
- The fund's return will differ slightly from the index because of fees and costs; Wikipedia describes an index fund's tracking error as near zero, not zero.
An actively managed fund, as the SEC describes it, relies on the skill of a manager who may buy or sell investments without conforming to an index. An index fund does something deliberately simpler: it tries to match the market, or a particular slice of it, as closely as possible. Investor.gov's definition is precise. An index fund is a mutual fund, exchange-traded fund (ETF) or unit investment trust that follows a passive investment strategy designed to achieve approximately the same return as a particular index, before fees.
What "tracking an index" means
An index is a list of securities with a rule for weighting them, such as the S&P 500, which follows large US companies weighted by their market value. It is a measuring stick; you cannot invest in it directly. What is a stock market index? explains how the main ones are built.
An index fund turns the measuring stick into something you can own. Investor.gov describes the method: the fund invests primarily in the securities of the companies included in the selected index, and some index funds also use derivatives, such as options or futures, to help achieve their objective. The SEC's bulletin on fund characteristics adds that the strategy can be carried out by buying all the securities in the index or a representative sampling of them. When the index's membership or weights change, a fund replicating it has to trade to keep matching.
Why they tend to cost less
Investor.gov lists the usual advantages of passive management:
- Less trading, which means lower transaction costs inside the fund.
- More favourable tax consequences, because less trading realises fewer capital gains.
- Lower fees and expenses than actively managed funds.
It also states the reason this matters: over time, higher fees and expenses can significantly lower investment returns. The SEC's fee bulletin explains that operating expenses are paid out of fund assets, reducing the value of every investor's shares, whether or not the fund performs well.
Why a fund never exactly equals its index
Investor.gov's wording is "approximately the same return... before fees", and Wikipedia's article on tracking error says index funds are expected to replicate an index's return before trading and other costs. The gaps come from things the index itself does not have:
- Fees and expenses, paid out of fund assets.
- Trading costs when the fund buys and sells to keep matching.
- Sampling, if the fund holds a representative sample rather than everything.
Wikipedia defines tracking error as the standard deviation of the difference between a portfolio's returns and its benchmark's, and describes an index fund's as near zero: small, but not nothing.
What an index fund does not do
- It does not avoid market losses. If the index falls 20%, a fund tracking it falls about 20%. Index funds remove the risk of picking the wrong company within the index, not the risk of the index itself.
- It does not judge value. A market-weighted index fund holds more of whatever has risen in market value, whether or not that rise is justified.
- It is only as diversified as its index. A fund tracking a narrow sector index is concentrated in that sector. Diversification explained covers what spreading risk can and cannot do.
Mutual fund or ETF?
"Index fund" describes the strategy, not the legal wrapper. The same index may be tracked by mutual funds and ETFs, which differ in how they trade, how they are priced and how they are taxed. ETFs versus mutual funds compares them.
Questions worth asking about any index fund
- Which index, exactly? "US stocks" can mean the 500 largest companies or several thousand of all sizes. The index decides what you own.
- How many holdings, and how concentrated? A market-weighted index can have a large share in its biggest companies.
- Does it replicate or sample? Sampling can widen the tracking difference.
- What does it cost? The expense ratio, plus any sales charges or trading costs.
- Which structure? A mutual fund and an ETF tracking the same index trade and are taxed differently.
- What do the documents say? The SEC recommends reading the prospectus, which every registered fund provides free.
Reading the numbers
When comparing index funds that track the same index, two figures speak directly to its one job: the expense ratio, and how closely the fund's past returns have followed its benchmark. Past tracking does not guarantee future tracking, but large, persistent gaps are worth asking about. How small annual differences compound over decades is shown in compound interest explained, and the idea of investing a fixed amount on a schedule is covered in dollar-cost averaging.
To learn the mechanics behind prices and orders before thinking about funds, Learn to Trade Stocks Beginner lets you practise with a virtual balance. It is one of our education apps; the investing basics hub lists the related guides.
Good to know
Frequently asked questions
What is an index fund?
Can an index fund lose money?
Why do index funds usually cost less?
Is an index fund a mutual fund or an ETF?
Sources
- Index Fund (glossary) (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Characteristics of Mutual Funds and Exchange-Traded Funds (ETFs) – Investor Bulletin (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Mutual Fund and ETF Fees and Expenses – Investor Bulletin (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Tracking error (opens in a new tab)Wikipedia — accessed
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