How an Index Fund Works
A stock market index is a list of companies selected by a rules-based methodology. The S&P 500 tracks the 500 largest US publicly traded companies by market capitalisation. It's just a list — it holds no actual stocks. An index fund holds the actual stocks to replicate the index's performance.
When you invest in an S&P 500 index fund, you own a tiny slice of all 500 companies. If Apple makes up 7% of the S&P 500's total value, Apple is approximately 7% of the fund. When the index rises 10%, the fund rises approximately 10% (minus a small fee). When the index falls, the fund falls by the same amount.
The fund manager's role is purely mechanical — replicate the index. No analysis, no stock picking, no market timing. This simplicity is what makes costs so low and performance so consistent relative to benchmarks.
Types of Index Funds
- S&P 500 index funds: Track the 500 largest US companies. The starting point for most investors. Examples: VOO, IVV, FXAIX.
- Total market index funds: Track the entire US stock market — thousands of companies including small and mid-cap. Broader diversification. Examples: VTI, ITOT, FZROX.
- International index funds: Track stocks outside the US — developed markets (Europe, Japan, Australia) or emerging markets (India, China). Add geographic diversification. Examples: VXUS, IXUS.
- Bond index funds: Track fixed income. Lower expected returns, lower volatility. Used to balance a portfolio. Example: BND, FBND.
- Sector index funds: Track specific industries. More concentrated risk — generally not a portfolio core.
Index Funds vs Actively Managed Funds
Actively managed funds pay analysts and portfolio managers to pick stocks. The logic is appealing. The evidence is consistently unfavourable to active management.
S&P Global's SPIVA Scorecard — which tracks active fund performance against benchmarks — shows that over 15-year periods, approximately 85–92% of actively managed US equity funds underperform their index benchmark after fees. The few that outperform don't reliably do so in subsequent periods.
The arithmetic: the average active manager charges 0.5–1.5% more per year than an index fund. That fee comes directly from returns. After fees, the average active manager underperforms by approximately the fee amount — by mathematical necessity.
Warren Buffett's instructions for his estate include 90% in a low-cost S&P 500 index fund. Jack Bogle, who invented the index fund, built his entire legacy on this insight.
How to Start Investing in Index Funds
- Open a tax-advantaged account first. 401(k) (employer sponsored), IRA, or Roth IRA. Then taxable brokerage if you've maxed those.
- Choose your fund. A total US market fund (Vanguard VTSAX, Fidelity FZROX) plus an international fund (VXUS) gives you the whole world at low cost. The classic three-fund portfolio adds a bond fund for balance.
- Set automatic monthly contributions. Dollar-cost averaging — investing a fixed amount regardless of market price — removes the temptation to time the market.
- Stay the course. Don't sell during downturns. The returns of index investing come from staying invested through volatility, not from reacting to it.
Understanding Expense Ratios
The expense ratio is the annual fee as a percentage of assets. 0.03% on $10,000 costs $3/year. 1.0% costs $100/year. The difference compounds enormously over time.
| Fund Type | Typical Expense Ratio | Cost on $100,000 |
|---|---|---|
| Index fund (Fidelity FZROX) | 0.00% | $0/year |
| Index ETF (Vanguard VOO) | 0.03% | $30/year |
| Index mutual fund | 0.03–0.20% | $30–$200/year |
| Actively managed fund | 0.5–1.5% | $500–$1,500/year |
On $100,000 invested for 30 years at 7% gross return: a 0.03% expense ratio produces ~$757,000. A 1.0% expense ratio produces ~$574,000. The 0.97% fee difference costs ~$183,000.
Index Investing in the UK, India, and Canada
UK: FTSE 100 (UK's 100 largest companies) and FTSE All-World index trackers are widely available. Vanguard UK, iShares, and HSBC offer low-cost trackers. Best vehicles: Stocks and Shares ISA (tax-free growth and withdrawals) and SIPP (pension, tax-deductible contributions). FCA guidance at fca.org.uk.
India: Nifty 50 and Sensex index funds are available from UTI, HDFC, Nippon India, and others at 0.10–0.20% expense ratios — very competitive. Invest through SIPs for automated monthly investing. Best vehicles: ELSS funds (tax saving + equity exposure), NPS (pension), and regular demat/mutual fund accounts. SEBI at sebi.gov.in.
Canada: Vanguard Canada (VEQT), iShares (XEQT), and BMO offer all-in-one global equity ETFs at ~0.20% — a single ticker for diversified global index investing. Best vehicles: TFSA (tax-free growth and withdrawals, no contribution tax deduction) and RRSP (tax-deductible, deferred until withdrawal). FCAC at canada.ca.