What an index fund actually is

Index investing is frequently described as owning the market, which is a useful shorthand that conceals a series of decisions made by whoever constructed the index.

What an index is

A rules-based selection and weighting of securities.

The rules determine which securities are included, how they are weighted, when the composition changes and how corporate actions are handled.

These rules are decisions made by an index provider, which means an index is a product rather than a natural object.

Which is why two funds both described as tracking a market can hold substantially different things.

Weighting

The most consequential decision.

Market capitalisation weighting, which is the most common, holds securities in proportion to their market value.

Which means the largest companies dominate, and in recent years a small number of very large companies have come to represent a substantial share of some major indices — a concentration that surprises people who believed they were diversified.

Equal weighting holds each constituent in the same proportion, which increases exposure to smaller companies and requires more rebalancing.

Factor and fundamental weighting uses other measures, which is a different proposition with different risks.

Checking the concentration of a fund's top holdings takes a minute and frequently changes people's understanding of what they own.

Coverage

What is actually included.

A national large-company index covers a small number of large domestic companies and is not a diversified portfolio.

A developed-world index covers many countries and excludes emerging markets.

A global all-cap index covers developed and emerging markets across company sizes and is the broadest common option.

Which means the difference between funds is frequently coverage rather than quality, and comparing them requires reading what each actually holds.

Home bias — holding a disproportionate share in your own country — is common and is a deliberate choice worth making consciously rather than by accident.

Physical and synthetic replication

How the fund tracks the index.

Full physical replication holds every constituent in the correct proportion.

Sampling holds a representative subset, which is used where full replication would be impractical or expensive.

Synthetic replication uses derivatives to deliver the index return, which introduces counterparty risk and can be cheaper or more effective for certain markets.

Most retail investors are best served by physical funds, and understanding which you hold is worthwhile.

Tracking difference and tracking error

Two related measures.

Tracking difference is the gap between the fund's return and the index return, which reflects costs, cash drag, tax on dividends and securities lending revenue.

Tracking error measures the volatility of that difference.

A fund can have low costs and poor tracking, or slightly higher costs and better tracking, which is why the headline charge is not the whole picture.

Comparing several years of tracking difference against the stated charge is the useful check.

Costs

Where the visible and invisible sit.

The stated ongoing charge covers management and administration.

Transaction costs within the fund are separate and are disclosed in some jurisdictions.

Platform or custody fees are charged by whoever holds the fund for you and can exceed the fund charge for small portfolios.

Bid-offer spreads and, for exchange-traded funds, trading costs and spreads.

And currency conversion costs where relevant.

The total cost of ownership is what matters, and comparing only the fund charge misses a substantial part of it.

Accumulating and distributing

A practical distinction.

Accumulating share classes reinvest income automatically, which is simpler for long-term investors.

Distributing share classes pay income out, which suits people who want the income and which requires reinvestment decisions otherwise.

Tax treatment differs in some jurisdictions, including for accumulating funds where income is taxable despite not being received.

Which is worth checking rather than assuming.

The evidence for indexing

Stated briefly.

Long-run studies comparing active funds against their benchmarks after costs consistently find that a majority underperform over longer periods, with the proportion rising with the period examined.

Persistence of outperformance is weak, meaning past winners do not reliably continue.

The arithmetic underlying this is straightforward: in aggregate investors hold the market, so before costs the average active investor earns the market return, and after costs earns less.

Which is the case for indexing, and it is a case about costs and arithmetic rather than about markets being efficient.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.