How it works
Most share indices weight companies by their size on the market: a company worth five times another has five times the weight. An index fund simply holds each in that proportion. When prices move, the weights move with them, so the fund has little buying and selling to do.
Because there is no research into which companies to prefer and little dealing, an index fund is cheap to run and its yearly charge is usually low. Its result is the index’s result, minus that charge and the small costs of following the index. It cannot beat its index, and it should not fall far behind it.
The charge matters more than it looks. It is taken every year from the whole amount, so the money it removes also loses all the growth it would have had. Over decades a difference of one percentage point a year becomes a large share of the final sum. The arithmetic on this page shows it for any assumption the visitor chooses.
The first index fund open to the public was launched in the United States in 1976. Index funds are sold both as mutual funds and as exchange-traded funds; the idea is the same in either wrapper.
What it costs
- The fund’s ongoing charge, taken each year as a percentage of the amount held.
- Tracking difference: the small amount by which the fund’s result differs from the index after dealing costs and taxes inside the fund.
- A platform charge for holding the fund, and a dealing charge in some accounts.
- The spread, when the fund is an ETF bought on an exchange.
The risks
- An index fund falls as far as its index. In a broad market fall it has nowhere to hide and no manager to step aside.
- A size-weighted index puts the most money into the largest companies, so a handful can make up a large part of the fund.
- “Index” does not mean broad. An index of one sector or one small market is a narrow bet with an index’s name.
- Currency risk, when the index’s companies are priced in other currencies.
- Long periods of poor returns happen. Decades are made of years, and some of them are bad.
Where people go wrong
- Taking an assumed growth rate for a promise. Any figure typed into a calculator is a guess about the future.
- Believing an index fund is low risk because it is low cost. Cost and risk are separate things.
- Selling after a fall and buying back after a rise, which turns a market’s return into something worse.
- Not checking which index a fund follows. Two funds with similar names can hold very different lists.
- Ignoring a small difference in fees because it is small in any one year.
Questions people ask
- What is an index fund?
- A fund that holds the securities of a published index in the index’s own proportions, so that its return follows the index. It does not try to pick the better companies or to avoid the worse ones.
- How much difference does a fund’s yearly fee make?
- More than its size suggests, because it is taken every year from the whole amount and compounds. Each year the fund keeps (1 − fee) of what it would otherwise have had, so after many years the shortfall is that factor multiplied by itself once per year. The calculator on this page works it out for any growth rate you assume.
- Can an index fund lose money?
- Yes. It holds what the index holds, and when those prices fall the fund falls with them. Following an index removes the risk of a manager choosing badly; it does not remove the risk of the market itself.
The words on this page
A general explanation for study, with invented examples. Costs, taxes and rules differ by country, market and product, and the documents of the thing itself are what count. Educational information, not investment advice or a recommendation to trade.