How an Index Fund Actually Works

What an index is, before anything else

Neha has been told to buy an index fund and has not been told what an index is. It is worth being precise, because most of what follows falls out of the definition.

An index is a rule for computing a number from a list of companies. Somebody decides which companies are in the list, how much weight each carries, and when the list changes. Then the number is the weighted total of their prices, restated so it can be compared over time.

Two things follow immediately. An index is not a portfolio — it is a calculation, and it has no costs, no cash and no need to actually buy anything. And an index is a set of decisions somebody made, not a natural fact about the market. Which companies, weighted how, reviewed when: all choices, made by a committee, written down in a rulebook.

What the fund does

An index fund holds the companies in the list, in the weights the rule specifies, and adjusts as the rule requires.

The most common weighting is by size — each company's weight is proportional to the total market value of its shares. That has a convenient property worth understanding: if weights are proportional to size, the portfolio needs almost no trading to stay correct. When a company's price rises, the value of the fund's holding rises by exactly the same proportion, and the weight updates itself. Nobody has to buy or sell anything.

This is the quiet reason index funds are cheap. It is not primarily that nobody is being paid to pick shares; it is that the portfolio maintains its own weights, and trading is what costs money.

When it does have to trade

Four occasions, and they are where the differences between funds live.

When the index changes its members. Periodically the committee adds and removes companies, and every fund tracking that index must buy the new one and sell the old one at around the same time. Since everyone knows in advance, the price of an entering company tends to be bid up before the funds get there. This is a genuine cost of tracking an index and it does not appear in any fee.

When money arrives or leaves. New investors mean new units and new purchases; redemptions mean sales. A large, stable fund does much of this by netting one against the other and trades less.

When dividends arrive. The index assumes dividends are reinvested instantly; the fund receives them on a real date and reinvests them on another. The mismatch is small and it is always there — which is also why the index a fund is measured against must be the total return version: price return against total return.

When corporate actions happen. Mergers, splits, rights issues. The index applies a rule; the fund has to execute something.

Why the fund never quite equals the index

Add the above to the annual charge and you have the full list of reasons a fund lags: the fee, trading around index changes, cash awaiting investment, and dividend timing.

The result is a shortfall that is small each year and compounds. Measuring it properly means distinguishing the size of the shortfall from its variability, which are two different quantities with confusingly similar names — tracking error against tracking difference.

Some funds hold every constituent; others hold a representative subset chosen to behave like the whole, which is cheaper to run and tracks slightly less precisely. For a large-company index full replication is straightforward. For a broad index containing many small and thinly traded companies, it is not, and sampling becomes more common — which is a reason a fund tracking a broader index usually tracks it less tightly.

What you are and are not getting

You get the market's result, minus a small and knowable amount. Not the average fund's result — the index's, less the shortfall above. That is the entire proposition and it is a good one.

You do not get protection from falls. An index fund holds the market, so it falls when the market falls, in full. There is no judgement inside it to reduce exposure, which is the point: judgement is what you decided not to pay for.

You do not get a diversified portfolio just because the index is broad. An index weighted by size will be concentrated in whatever has grown largest, and a broad index can have a great deal of its value in a handful of companies or one or two industries. That is a real risk of the approach and it has its own page — the advantages and risks of index investing.

And you do not escape the choices. You have chosen the committee's rulebook: which companies count, weighted how. That is a smaller set of decisions than picking shares, and it is not none.

What to check before buying one

The index it tracks, and whether that index is what you actually want to own. The annual charge. The tracking difference over the longest period available, against the total return version of the index. And the fund's size, because a very small index fund carries proportionally higher fixed costs and has more difficulty matching index changes cleanly.

Whether to buy the fund or the exchange-traded version of the same thing is a separate question decided mostly by how you transact rather than by the products — ETF or index fund.

What to take away

An index is a rulebook; a fund is an attempt to follow it. The attempt costs a little, mostly in fees and in trading when the rulebook changes, and that cost is the whole difference between what you read in the news and what you get.

Which makes the useful questions narrow and answerable in advance: which rulebook, what charge, and how closely has this fund managed to follow it.