Index fund

An index fund follows a set of published rules instead of a manager’s judgement. The index provider decides which securities are in the index and in what proportions, usually weighted by market capitalisation, and the fund buys the same securities in the same proportions, or a representative sample of them. When the index changes, the fund changes. Because there is no research team picking stocks and turnover is low, running costs are usually much lower than for an actively managed fund. Index funds can be structured as traditional open-ended funds, priced once a day, or as ETFs traded on an exchange.

The appeal rests on simple arithmetic: before costs, all investors in a market together earn the market’s return, so after costs the average active investor must trail a cheap index fund. An index fund will never beat its index, but apart from its fees and tracking difference it will not badly lag it either. The common misunderstanding is that index funds are riskless or ‘safe’. They carry the full risk of the market they track, and a fund tracking a narrow or concentrated index can be far from diversified.