Index Funds — What They Do and What They Do Not

An index is a defined list of companies with defined weights, maintained by an index provider according to published rules. An index fund holds those companies in those weights and adjusts when the index itself changes.

There is no view being taken. If a company enters the index, the scheme buys it; if one leaves, the scheme sells it. Nobody is deciding that a particular business looks attractive, which is precisely the point.

An exchange traded fund does much the same thing but trades on an exchange like a share, which means it needs a demat account and its price through the day can differ slightly from the underlying value. An index fund bought as a normal scheme needs no demat account, which for most household investors is simpler.

Two arguments, and only one of them is about performance.

Cost. Index funds typically carry lower expense ratios than actively managed schemes, because there is no research team deciding what to hold. Cost is the one number knowable in advance, applies every year regardless of what markets do, and is the difference nobody markets to you. Our page on expense ratio explains why that matters more than it appears to.

No manager risk. An index fund cannot underperform its category because the manager made poor calls, changed style, or left. It also cannot outperform for those reasons. You are exchanging one uncertainty for a different, smaller one.

What we are not going to do is tell you index funds beat active funds, or the reverse. That comparison depends entirely on the period, the category and the specific schemes chosen, and anybody presenting it as settled has picked the window that supports their case.

This is the part that surprises people who arrive expecting safety.

An index fund holds the market. When the market falls, it falls with it, fully. There is no manager stepping aside, no cash buffer being raised, no defensive positioning. Tracking is tracking in both directions.

It also does not remove the horizon question. An index fund on equities is an equity investment, so money needed within two or three years does not belong in one, whatever its cost advantage. And it does not remove the behaviour question either: the investor who stops during a fall gets the same poor outcome regardless of how cheaply the scheme was run.

If two schemes track the same index, the portfolios are near identical, so there are only a few things worth looking at.

• Expense ratio. Directly comparable here in a way it rarely is elsewhere, since the holdings are the same.
• Tracking error and tracking difference. How closely the scheme has actually followed the index, and by how much it has lagged. A cheaper scheme that tracks poorly is not cheaper in any useful sense.
• Size and liquidity of the scheme, which affects how easily it manages inflows and redemptions.

Those three are genuinely comparable and mostly published. Which is a pleasant change from most fund comparisons, where the honest answer is that you cannot know in advance.

An index fund is a way of holding equity exposure, not a category of its own in the sense that large cap or debt is. So the ordinary rules still apply.

The buffer comes first, as our page on building an emergency fund sets out. Near-term money stays in deposits. The horizon decides the exposure, and only then does the question of tracking versus selecting arise.

One more thing worth knowing before choosing this route. An index fund does exactly what it says on every single day, including the days you would rather it did something else. There is nobody to ring and no discretion to appeal to, and for some investors that is precisely the appeal while for others it is uncomfortable. Knowing which of the two you are is more useful than any comparison of costs.

Which index matters too, since indices differ considerably in what they cover. A broad one and a narrow sectoral one are very different propositions despite both being described as index funds, and the categories they draw from are explained on our page about large, mid and small cap funds.

One practical caution about narrow indices. A sectoral or thematic index fund is still an index fund by construction, but it holds a concentrated slice of the market rather than a broad one, so it behaves nothing like a broad-market scheme despite the shared label. The low-cost, no-manager-risk argument applies to both; the diversification argument applies only to the broad one.

We are distributors rather than investment advisers and we do not recommend schemes on this site. If you would like to talk through whether this approach suits your situation, get in touch.