Index funds: the boring investment that beats most professionals

What an index fund is

An index is a list of companies chosen by a fixed set of rules, plus a rule for how much weight each one gets. The S&P 500, for example, tracks about 500 large US companies. Other indexes cover one country, a region or the whole world. On its own, an index is only a measurement.

An index fund buys the companies in an index in the same proportions, so its return follows the index, minus its costs. No manager decides which companies look cheap or which sector will do well next year. Instead of trying to find the needle, you buy the haystack.

The fund is cheap to run, because it needs no analysts, and it trades rarely, because it only changes when the index changes. You get the market's return minus a small fee, which over long periods most professional fund managers have failed to beat.

How market-cap weighting works

Most large indexes are weighted by market capitalisation: the total value of all of a company's shares. Bigger companies get a bigger share of the fund.

Imagine an index of three companies worth 600 billion, 300 billion and 100 billion. Their weights are 60%, 30% and 10%. If you invest 1,000, the fund puts 600 into the first company, 300 into the second and 100 into the third.

Now say the first company's share price doubles and the other two stay flat. Your holdings are now 1,200, 300 and 100, a total of 1,600. The weights are 75%, 18.75% and 6.25%, which is exactly what the index now says. The fund did not need to trade to keep up, which is one reason cap-weighted funds have low trading costs.

The trade-off is concentration. When a few very large companies grow fast, your fund depends more on them. That is not a flaw to fix, but you should know what you own.

Total market, S&P 500 or global all-world

Three broad types cover most people's choices:

• S&P 500 funds hold about 500 of the largest US companies. They cover most of the US market by value, but only one country.
• Total market funds hold almost every listed company in one market, often several thousand. For the US, the result behaves much like an S&P 500 fund, because the largest companies dominate either way.
• Global all-world funds hold large and mid-sized companies across developed and emerging markets, usually thousands in a single fund. Each country appears in proportion to its market value, so the US has made up more than half of these indexes in recent years.

A global fund spreads your money across many economies and currencies, which matters if you live outside the US. Single-country concentration has hurt before: Japan's main stock index took about 34 years to climb back above its 1989 peak, measured by price alone. US shares have done very well over recent decades, but past returns do not decide which country leads next.

Whichever fund you pick, decide your mix of shares, bonds and cash first. Our guide to asset allocation covers that step, and the asset allocation tool shows your current split.

Low costs compound in your favour

Every fund charges a yearly fee, taken out of the fund's value. Broad index funds are often among the cheapest you can buy. Active funds usually charge more, and the difference compounds.

Take 100,000 invested for 30 years with no further deposits. To keep the arithmetic clean, say a low-cost index fund returns 6% a year after costs, and a fund that costs 0.8% a year more returns 5.2%. Both rates are assumptions for the example, not forecasts; real returns vary and can be negative.

Figures are rounded to the nearest whole unit.

After 30 years, the more expensive fund ends with about 20% less money. Measured against growth alone, the extra cost takes about a quarter: 116,764 out of 474,349. You never see this as a bill. It is growth you never received. Our post on compound interest shows the same effect from the other side.

Higher costs would be fine if expensive funds reliably earned them back. Most do not. S&P's SPIVA reports have found, year after year, that most actively managed US large-cap funds trail the S&P 500 over 10 and 15 year periods. SPIVA's European scorecards have reported similar results for many fund categories. Some active managers do beat the market, but it is hard to know in advance which ones, and few keep it up.

When you compare costs, add up the full amount: the fund's ongoing charge, any platform or account fee, trading costs and currency conversion fees.

ETF or mutual fund, accumulating or distributing

ETF or mutual fund

An index fund can come as an exchange-traded fund (ETF) or as a traditional mutual fund. Both can track the same index at low cost.

• ETFs trade on a stock exchange during the day, at a market price, through a broker. There is a small gap between the buying and selling price, called the spread.
• Mutual funds are bought and sold once a day, at that day's price. Many let you invest an exact amount each month, which makes automatic investing simple.

The index matters more than the wrapper. Choose whichever your platform offers at the lowest total cost.

Accumulating or distributing

Many funds, especially in Europe, come in two share classes. A distributing class pays dividends out to you as cash. An accumulating class reinvests them inside the fund, so the unit price rises instead.

Accumulating classes make reinvestment automatic. Distributing classes suit people who want the income. Each country taxes the two types in its own way, so check the rules where you live before you choose.

How to start

The method is simple; following it for decades is the hard part.

1. Build an emergency fund first. If you need cash during a downturn, you do not want to sell shares at a low price to get it.
2. Use a tax-advantaged account if your country offers one. The rules vary a lot by country.
3. Choose one broad fund or a simple mix, and write down why. You will want that note in a bad year.
4. Set up an automatic monthly purchase for the day after payday. You buy more units when prices are low and fewer when they are high.
5. Leave it alone. Look at it once a month at most, and review your mix once a year.

Here is why step 4 helps. Say you invest 200 a month. In month one the price is 100, so you get 2 units. In month two the price has halved to 50, so the same 200 buys 4 units. In month three it is back to 100, so you get 2 units. You have invested 600 for 8 units, an average cost of 75 per unit, and at a price of 100 they are worth 800. Real markets rarely recover this neatly and can stay low for years, but the principle holds: buying through a fall only helps if you keep buying.

What an index fund will not do

It will not protect you from crashes

An index fund owns the market, so it falls with the market. From its 2007 peak to its low in 2009, the S&P 500 lost more than half its value. A global fund spreads the risk across countries, but in a worldwide crash most markets fall together. If you need the money within a few years, it probably should not all be in shares.

It will not beat the market either. By design, you get the market's return minus costs. If your aim is to outperform, an index fund cannot do that for you.

Behaviour is the biggest risk

The largest risk to an index fund investor is usually the investor. The fund does its job quietly; people undo it with a few bad decisions at the worst times.

An index fund can only deliver the market's return to people who stay invested long enough to receive it.

Tracking index funds in worthtracker

Record each fund account as an asset in the stocks category and update its value once a month. There are no bank or broker connections in worthtracker, so you type the value in yourself. The app records a snapshot of your net worth on your first visit each month, and over the years that history shows a bad month in context: one point among many.

The free plan includes unlimited assets, CSV export, goals and milestones. Pro adds FIRE projections and unlimited snapshots. You can start free.