What is an Index Fund, and How Do They Work?

An index fund allows investors to own a diverse basket of stocks and copy the returns of the stock market. But what are the drawbacks?

by | Last updated 8 Dec, 2022 | Investment Funds

Entrance to the New York Stock Exchange on Wall Street

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The popularity of index funds (also known as index trackers) has been growing at an accelerating pace in recent years. The term describes either a mutual fund or an exchange-traded fund (ETF) which tracks a specific stock market index.

As a quick reminder, an investment fund takes shareholder capital and invests it in a portfolio of carefully selected financial securities. In the case of an index fund, the investment portfolio consists entirely of the constituent stocks inside the specified stock market index. The weighting of each position within the portfolio typically matches the index’s weighting as well.

This investment vehicle provides a convenient, cost-effective way for investors to quickly diversify and match the stock market’s performance in general. Markets rise over long time frames. And by investing in a stock index fund, investors can capitalise on this long-term trend with minimal fees and almost no effort, effectively putting their investments on autopilot.

Today there are over 5,000 indices listed in the United States, with the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite being three of the most popular. The flagship indices in the United Kingdom include the FTSE 100, FTSE 250, and FTSE 100 All-Share.

How do index funds work?

Regardless of whether an index tracker is an index mutual fund or an index ETF, the core principles are the same. The fund manager takes shareholder capital and invests it in the shares of all companies within the index being tracked.

Therefore, if investors buy shares in an FTSE 100 index tracker fund, they indirectly purchase the shares of all 100 constituent companies within a single transaction.

Today most index funds are run by automated trading algorithms, as investment decisions by the fund manager aren’t based on research. Instead, positions are opened, adjusted, and closed based on the shifting makeup of an index. Typically the fund’s portfolio will be rebalanced once a quarter in line with the rebalancing of indices.

As there is no need for investment research or stock analysis, index trackers are almost always passive funds. Consequently, the annual management fees are notoriously low, with an average cost typically between 0.05% and 0.1% per year.

What are the advantages of an index fund?

An index fund provides a broad range of advantages to investors, including:

  • Instant diversification – Investors can buy a large basket of stocks within a single transaction providing ample diversification to an investment portfolio.
  • Low fees – Index funds are low-cost investment vehicles, and most are significantly cheaper than actively managed funds. They are also a far more cost-effective method of investing in a broad range of companies than buying shares directly in each constituent business and paying a commission fee on each transaction.
  • Beginner-friendly – Novice investors can start investing their capital with minimal knowledge of the stock markets or stock analysis.
  • Solid long-term returns – Index trackers replicate the performance of the stock market. And historically, over the last 50 years, the stock market has, on average, delivered returns close to 10% annually.
  • Easier than stock picking – By investing in an index fund, investors do not have to deal with the challenges, risks and efforts of picking individual stocks.

What are the disadvantages of an index fund?

While index funds provide a lot of powerful advantages, they’re not without drawbacks.

  • Limited performance – Index funds are designed to track a stock market index. As such, it’s impossible to achieve market-beating returns using these investment vehicles.
  • No flexibility – Because index trackers do not exclude specific companies, investors may end up owning shares that do not align with their ethical or moral principles. Typical offenders include alcohol, tobacco, gambling, adult industry, and weapon manufacturing businesses. These are more commonly referred to as Sin Stocks.
  • Volatility – The share price of a stock index fund is subject to the same volatility of the index it’s tracking. During economic or geopolitical turmoil, stock market volatility can surge, harming even the most diversified portfolios.
  • Potential for tracking errors – Because of the management fees charged to shareholders, and the commission fees paid by the fund during each rebalancing event, there can be discrepancies between the performance of the fund and the underlying index it’s tracking.

There are thousands of tracker funds for investors to choose from, each charging its own management fees. The table below lists some of the most popular.

IndexTracker Fund
FTSE-All Share IndexHSBC FTSE All Share Index Fund
FTSE 100 HSBC FTSE 100 Index Fund
iShares Core FTSE 100 UCITS ETF
Vanguard FTSE 100 UCITS ETF
FTSE 250HSBC FTSE 250 Index 
Invesco FTSE 250 UCITS ETF
iShares FTSE 250 UCITS ETF
Vanguard FTSE 250 UCITS ETF
S&P 500Vanguard S&P 500 ETF 
Fidelity 500 Index Fund 
Dow Jones Industrial AverageSPDR Dow Jones Industrial Average ETF Trust
Nasdaq 100Invesco Nasdaq 100 ETF

Index funds vs actively managed funds

Index funds aim to track the performance of a stock market index through passive investing. On the other hand, an actively managed fund seeks to outperform the stock market through careful research and analysis, using an index as a benchmark.

Investment funds using active investing strategies open the door to superior returns. However, this also comes paired with higher management fees. And on average, most active mutual funds actually fail to deliver market-beating returns, with most shutting down within five years of launching.

This is one of the main reasons why legendary investor, Warren Buffett, is an advocate for low-cost passive index trackers. He once said, “In my view, for most people, the best thing to do is to own the S&P 500 index”

Factors to consider when choosing an index fund

As previously mentioned, there are thousands of index trackers for investors to choose from. Many of which are tracking the same indices. Yet not all funds are the same, and there are several points investors need to investigate before making an investment decision.

What are the costs associated with index funds?

Index funds charge annual recurring management fees, which can eat into returns. However, some may also introduce additional costs, such as initial and exit charges. Combined, these fees culminate into the expense ratio that must be considered. Additionally, a minimum investment requirement may be in place, raising the entry barrier for investors.

How much does the average index fund make?

As index funds aim to track a specific index, their annual performance will closely match the returns of the index being tracked. Historical performance can provide insight into what level of returns investors can expect to receive in the long term. However, it’s important to remember that past performance is not a reliable indicator of future returns. And it’s possible to end up with significantly less than expected.

Do index funds pay dividends? 

As shareholders indirectly own shares in the businesses within the fund’s portfolio, they are entitled to dividend payments.

There are two primary dividend policies that an index tracker can adopt:

  • Accumulation – Dividends received from companies in the portfolio are automatically reinvested, increasing the size of the pot and boosting the fund’s share price.
  • Income / Distribution – Dividends received from companies in the portfolio are paid out to shareholders as cash to their brokerage account.

Are index funds taxable?

Yes. Any capital gains or dividends earned from an index fund investment are subject to regular tax treatments. However, investors can reduce or outright eliminate tax expenses by using a tax-efficient investment account such as a Stocks and Shares ISA or Self-Invested Personal Pension (SIPP).

The bottom line

Most financial and investment advisers agree that index investing is an excellent choice for long-term investors deploying a buy-and-hold strategy. The low fees paired with strong diversification make them an ideal method for individuals to gain exposure to a wide range of companies, sectors, and international markets.

That said, they are not risk-free. And investors need to consider their time horizon, risk tolerance, and investment objective to determine whether an index fund is a suitable addition to their portfolio.

Continue Reading: How to invest in index funds

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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.

Prosper Ambaka does not have a position in any of the financial instruments mentioned in this article. The Money Cog does not have a position in any of the financial instruments mentioned in this article.

Written By

Prosper Ambaka, Esq.

Prosper is a self-taught financial analyst and investor with years of experience. Inspired by Benjamin Graham, he employs a value-investing school of thought throughout his analyses. This has led to Prosper developing a wealth of knowledge in equities, foreign exchange, commodities, and global macroeconomic issues.

In 2019, he completed his Law degree and was called to the Nigerian Bar in 2021. Outside The Money Cog, Prosper encourages others to join the investment community through his lectures on financial literacy as well as investing strategies.

Current Holdings


Edited & Fact Checked By
Zaven Boyrazian MSc

Zaven has worked in several industries throughout his career, from aircraft factories to game development studios. He has been actively investing in the stock market for the better part of a decade, managing over $1 million across multiple portfolios.

Specializing in corporate valuation, Zaven employs a modern take on the principles set out by Benjamin Graham to find new opportunities at fair prices.

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