Index Fund

An index fund is a mutual fund or ETF that tries to replicate the performance of a market index, such as the S&P 500 or MSCI World, instead of trying to beat it. The fund simply holds the index's constituents at the index's weights, which requires no expensive research and therefore costs very little.

Key takeaways

Index funds aim to match an index, minus a small fee; they make no judgement about which holdings are attractive.
The case for indexing is arithmetic: all investors collectively earn the market return before costs, so the average actively managed dollar must trail the market after costs.
SPIVA scorecards have found, period after period, that a large majority of active equity funds underperform their benchmark over 10-15 year horizons.
"Index fund" describes a method, not a risk level: an index fund is exactly as risky as the index it tracks.

The arithmetic of indexing

The argument was stated crisply by Nobel laureate William Sharpe in 1991: before costs, the average actively managed dollar and the average passively managed dollar earn the same market return, so after costs the average active dollar must earn less. Nothing about skill, just subtraction. John Bogle turned that observation into the first retail index fund in 1976, mocked at launch as "Bogle's folly" and "un-American".

The evidence has been kind to the arithmetic. S&P's SPIVA scorecard (year-end 2024) reports that roughly 90% of US large-cap funds underperformed the S&P 500 over the previous 15 years. Individual funds do beat the index, but identifying them in advance, and their persistence, is the hard part: SPIVA's persistence reports show top-quartile funds rarely stay top-quartile.

How tracking actually works

Full replication (buy everything in the index) works for liquid indexes. For huge or illiquid ones, funds use sampling or optimisation. Success is measured as tracking difference (the return gap versus the index, usually about equal to the expense ratio) and tracking error (the variability of that gap). A well-run S&P 500 fund with a 0.03% fee lags its index by about 0.03% a year, which is the whole product promise.

What indexing does not do

An index fund holds the market's losers along with its winners, by design. It concentrates where the index concentrates: cap-weighted indexes give the biggest companies the biggest weights, as described under market capitalization. And it offers no defence in a downturn; matching the index means matching its falls. Whether that trade-off fits a given person is a suitability question this encyclopedia does not answer.

Frequently asked questions

Is an index fund the same as an ETF?

No. Index fund describes the strategy (track an index); ETF describes the wrapper (exchange-traded). Index mutual funds and index ETFs both exist; see exchange-traded fund.

If everyone indexed, would markets stop working?

Price discovery needs some active trading, and academics debate where the limit lies. Active managers still set prices at the margin today, and indexing's share, while large, leaves an active market in place.