Index funds, explained properly

If you have read anything about investing you have been told to buy index funds, usually without being told what an index is. This guide fixes that, in order.

An index is a list, not a product

It is a roster of companies plus a rule for how much each one counts. That is genuinely all it is. Someone decides on a rule — the hundred largest companies listed in London, say, or several thousand companies across the developed world — and then publishes a number that summarises how that whole list is doing.

You cannot buy an index any more than you can buy a shopping list. What you can buy is a fund that has gone out and bought the things on it.

The rule matters more than beginners expect. Most well-known indices weight by size, meaning the largest companies make up the largest share. That is not a neutral choice — it means an index of thousands of companies can still have a meaningful chunk of your money in the biggest handful. Knowing that is not a reason to avoid it. It is a reason not to be surprised by it.

Tracking versus trying

This is the fork in the road, and it is the only genuinely contested question in this guide.

An active fund employs people to decide which companies to own. They research, they meet management, they form views, they buy what they believe will do well and avoid the rest. They charge you for this, because it is expensive to do.

A tracker, or index fund, does not decide anything. It buys the list. When the list changes, it changes to match. There is no view to be right or wrong about, and it costs very little to run because it needs almost no people.

The case for tracking is not that active managers are stupid. Many are extremely capable. The case is structural, and it comes in two parts.

• The average has to be the average. All the investors in a market collectively own that market, so collectively they earn the market's return before costs. That is arithmetic, not opinion. After costs, the group as a whole must therefore earn less than the market — and the more they are charged, the further below they land.
• You have to pick correctly, in advance. Some managers will beat the market over any given period. The difficulty is identifying which ones beforehand rather than afterwards, and past success is a famously unreliable guide.

So the tracker's proposition is modest and honest: you will not beat the market, and you will not have to. You will get close to what the market did, minus a very small amount, without needing to be right about anything.

That is what people mean when they say boring is undefeated. It is not that dull things are magically better. It is that the dull option removes two ways to lose — paying a lot, and picking wrong — and removing ways to lose turns out to be worth more than most attempts to add ways to win.

Fund, ETF, what's the difference

You will see the same underlying idea sold in two wrappers, and beginners waste a lot of energy on this. The honest summary is that the difference is mostly about how you buy the thing, not what you own.

• A traditional fund prices once a day. You put in an order, and it is executed at that day's single price, whenever it lands. You cannot control the moment.
• An ETF — exchange-traded fund — is listed on a stock exchange and trades all day like a share. You can see the price move and buy at a moment of your choosing.

For someone investing regularly over years, that distinction is close to irrelevant. Being able to trade at eleven in the morning rather than at the end of the day is worth nothing if you are holding for a decade. It only helps someone trying to be clever about timing, and being clever about timing is the thing the whole approach is designed to avoid.

What can differ meaningfully is the cost of each wrapper on your particular platform, and whether buying an ETF incurs a trading fee each time. That is a cost question, and cost questions have their own guide.

Accumulation or income

The same fund often comes in two versions, and the labels are not obvious.

• Accumulation — usually marked Acc. Dividends paid by the underlying companies are automatically reinvested inside the fund. You see no cash; the value of your holding simply rises to reflect it.
• Income — usually marked Inc or Dist. The dividends are paid out to you as cash.

Accumulation is the low-effort default for someone building up over time, because the reinvestment happens without you doing anything and without giving you a periodic opportunity to spend it. Income suits someone who actually wants the cash to live on. Neither is superior; they answer different questions.

What actually distinguishes one tracker from another

Once you have settled on tracking an index, two funds copying the same list are far more similar than the marketing suggests. The things genuinely worth comparing are short:

• Which index it tracks. This is the real decision, and it is a decision about what you want to own — one country or the whole developed world, large companies only or smaller ones too.
• What it charges. Covered properly in the next guide. Where the underlying holdings are identical, this is close to the only thing that separates them.
• Tracking difference. How far the fund's actual result drifts from the index it is copying. Small, but not always zero.
• How it is domiciled and structured. This affects tax treatment and is a genuinely technical area — worth reading the fund's own documentation rather than a summary.

Notice what is absent: how the fund performed last year. Two funds tracking the same index performed almost identically last year, because they both bought the same list. Choosing between them on recent performance is choosing on noise.

How a tracker actually copies a list

Worth a minute, because the phrase "tracks the index" hides three quite different methods.

• Full replication. The fund buys every company on the list, in the right proportions. Simple, transparent, and practical when the list is a few hundred large, easily traded companies.
• Sampling. The fund buys a representative subset chosen to behave like the whole. Used when a list runs to thousands of holdings and buying the long tail would cost more than it is worth. Slightly less precise, usually cheaper.
• Synthetic. The fund does not buy the companies at all. It enters a contract with a bank that agrees to pay it the index's return. This works, and it introduces a dependency on that bank meeting its obligations — a different kind of risk from the one you signed up for.

Most mainstream trackers are physical, meaning they actually hold the things. If a fund is synthetic it will say so in its documentation, and it is worth knowing which you own rather than discovering it later.

Choosing your index is the real decision

Once you accept tracking, the interesting question is no longer which fund. It is which list — because that is the decision about what you actually own.

The broad options run from narrow to wide: one country's largest companies, one region, all developed markets, or the whole world including developing economies. Wider generally means more companies, more countries and less dependence on any one economy going well.

The trap here has a name: home bias. Investors everywhere hold far more of their own country than its share of the world economy would suggest, because domestic companies feel familiar and safe. Familiarity is not diversification. If your salary, your house and your investments all depend on one economy, you are considerably more concentrated than you feel.

There is a real counter-argument — you spend in your own currency, so holding some assets in it reduces the currency swings you experience. That is a genuine consideration rather than an excuse. The point is to make the decision deliberately instead of arriving at it by accident.

Reading a factsheet without glazing over

Every fund publishes a two-page factsheet. Four things on it are worth your attention and the rest is largely decoration.

• The index it tracks — stated near the top. This tells you what you are buying better than the fund's name does, since names are marketing.
• The ongoing charge — the yearly cost, covered in the next guide.
• The top ten holdings and their combined weight — the fastest way to discover that your thousand-company fund has a third of its money in a couple of dozen names.
• Fund size — very small funds are occasionally closed and merged, which is not a disaster but can force a sale at a moment you did not choose.

What is not worth your attention is the performance chart, at least for choosing between trackers of the same index. They all did the same thing, because they all bought the same list.

Three mistakes beginners make with funds

These come up constantly and all three are avoidable.

• Buying five funds that own the same companies. Owning several funds feels diversified. If four of them are large global trackers, you have bought the same list four times, paid four sets of charges for it, and diversified nothing. Check what is inside, not how many lines are on the screen.
• Chasing whatever did best last year. Last year's winner is a description of the past. Buying it means buying something after it got more expensive, and the pattern of selling the laggard to buy the leader, repeatedly, is a fairly efficient way of buying high and selling low.
• Confusing a narrow theme with a sensible bet. Funds tracking a single trend or sector are indices too, but a list of forty companies doing one thing is a concentrated position wearing a diversified costume.

What the fund does with your dividends

The companies inside a tracker pay dividends, and those payments do not vanish — they are collected by the fund and handled according to which version you hold, as covered above. Worth knowing because it explains something confusing about index numbers you see quoted.

A published index level usually excludes dividends. A fund tracking it, however, receives them. So a tracker's return can legitimately look different from the index number quoted on the news, because the news figure is measuring the prices and your fund is also collecting the income.

Over a long period this is not a rounding difference. Dividends reinvested are a substantial part of the total return from owning shares, which is why comparing your fund against a price-only index number will make it look better than it is at tracking. Compare like with like, or do not compare at all.

Is active ever reasonable?

It would be dishonest to pretend the argument is entirely one-sided. Active management has a stronger case in corners of the market where information is genuinely scarce and hard to come by, where an index is difficult to construct sensibly, or where somebody is being paid to manage a specific risk rather than to beat a benchmark.

What has not been demonstrated is a reliable way for an ordinary investor to identify, in advance, which active manager in a mainstream market will be worth their fee over the next twenty years. That is the specific claim the tracker argument rests on, and it is a narrower claim than "active management is pointless".

The uncomfortable part

Tracking an index means you own everything on the list, including the companies you would never have chosen. There is no filter for quality, ethics or your own opinion. When part of the market is expensive and silly, you own the expensive silly part in proportion to its size.

That is the actual trade. You give up the ability to avoid the bad bits in exchange for not having to be right about which bits are bad. Most people, most of the time, come out ahead on that trade — but it is a trade, and anyone who tells you it is a free lunch is selling something.