index fund
A fund that holds the securities of an index in the same proportions instead of picking them.
An index fund is a fund that buys the securities in an index, in the same proportions, instead of having a manager pick them. An index is a rule-based list, for example all large and mid-sized companies in the world weighted by their market value. The fund's job is to match that list as closely and cheaply as possible.
Because there is no stock picking, index funds usually cost much less than active funds. Before costs, the average invested dollar earns the market return; after costs, the investors who pay less keep more of it. A broad index fund also owns the few big winners that drive most of the market's gains, since it owns everything.
An index fund is only as broad as its index. A world index spreads risk over thousands of companies; a single-sector theme index does not. It also falls with its market: index funds remove company-specific risk, not market risk.
Example
Zapas World Stock tracks the fictional Tessaro World index and holds about 3,000 companies at a 0.20% ongoing charge. In a toy market that earns 6% in a year, a passive investor paying 0.1% keeps 5.9%, while active investors paying 1.5% keep 4.5% on average: the same market, minus different costs.
Among 20 fictional active funds, 7 beat the index in the first 7-year period and none did it again in the second. The figures come from Zapas's synthetic course data, not from real funds.
Common mistakes
- Assuming every fund with "index" in its name is broad: a theme index fund holds one narrow slice.
- Expecting an index fund to avoid market falls.
- Comparing only headline fees instead of the full cost of owning the fund.
- Investments can fall, and you can get back less than you put in.
Learn it in the course
- Winners that don't repeat: luck, skill and closed funds · Where yesterday's top funds rank later, how dropping closed funds flatters the average and how long it takes to tell skill from luck.
- Reading a factsheet: index fund, ETF, accumulating, tracking difference, domicile · What the lines on a fund factsheet mean and which of them change what you actually pay and get.
- Case: "star manager picks" and a "hot theme" tab · Decide with fund and index data whether the app should add a star-manager tab and a hot-theme tab.
- Before and after costs: the arithmetic of the average investor · Why the average active dollar earns the market before costs and lags it by its costs after them.