Index Funds

Why this matters

Index funds are one of the simplest ways to own a broad slice of the market, and for many learners they're the core of the fund investor route described in How Hyperion Entities Works. Understanding exactly what they promise, and what they don't, keeps you from treating them as either magic or a mystery.

What an index fund does

An index fund is a mutual fund, ETF, or similar investment that follows a passive strategy: it aims to achieve roughly the same return as a particular index, before fees.¹ An S&P 500 index fund, for example, holds the companies in that index in about the same proportions, so its results rise and fall with the index.

That's different from an actively managed fund, where managers choose investments in an effort to beat a benchmark. The two approaches:

• Passive management aims to match the market and keeps trading to a minimum.
• Active management aims to beat the market by choosing what to buy and sell.

Why index funds can cost less

An index fund's managers don't need research analysts to choose investments, because the index already decides what to hold. Passive management also usually means less trading, which lowers trading costs and tends to produce fewer taxable gains. Together, that often adds up to lower fees than actively managed funds. Often, but not always: not every index fund costs less than every actively managed fund.¹

The arithmetic behind it

In a well-known 1991 paper, the economist William Sharpe pointed out a simple piece of logic. Before costs, the average dollar invested by active managers must earn the same return as the average dollar invested passively, because together they own the whole market. After costs, the average actively managed dollar must earn less, because active management costs more.²

That doesn't mean every active fund loses to every index fund. Some active managers beat the market in a given period. It means that, as a group, active investors can't beat the market after their higher costs. Whether skilled managers can be identified in advance is one of the most debated questions in investing, covered in Part 6 in Passive vs. Active Investing.

A fictional index returns 8.00% in a year. Three funds aim to match it.

Fund	Yearly costs	Return to investors, roughly
Low-cost index fund	0.05%	7.95%
Higher-cost index fund	0.60%	7.40%
The index itself	None. You can't invest in it directly	8.00%

Both funds hold the same companies. The only reason one delivers more than the other is cost. Every index fund trails its index slightly, because of fees, trading costs, and small imperfections in how closely it follows the index.³ Over decades, as Compounding showed, that small gap becomes a large one.

Choosing the index is a decision

"Index fund" describes the method, not what's being followed. An index fund can track 500 large US companies, every US company, small companies, a single industry, bonds, or stocks outside the US. As Market Indexes: What "The Market" Means showed, indexes differ in what they hold and how they weight it, and that shapes everything about the fund.

Some newer funds follow indexes built on custom rules, for example picking stocks by dividends, price, or other characteristics, rather than simply by size. They're still called index funds, but they behave differently from a broad market index, and the SEC has published an investor bulletin explaining them.⁴

Key takeaways

• An index fund aims to match an index's return before fees, rather than beat it.
• Index funds often cost less because they don't need analysts and trade less, but not every index fund is cheap.
• As a group, active investors can't beat the market after their higher costs, though individual funds can in a given period.
• The index a fund follows determines what you own and how it behaves.

Check your understanding

Why does an index fund's return usually come in slightly below its index?

1. Because of fees, trading costs, and small imperfections in tracking.
2. Because the fund manager chooses to leave out some companies in the index.
3. Because index funds are only allowed to hold half the index.

Two index funds track the same index. Fund A charges 0.04% a year and Fund B charges 0.50%. What's the most likely difference in what they deliver over 20 years?

1. None, since they own the same companies in the same proportions.
2. Fund B will do better, because higher fees pay for more careful management of the same index.
3. Fund A will very likely deliver noticeably more, because lower costs compound.

What's next

Before buying any fund, it pays to know how to check what it holds and what it costs. The next lesson, How to Read an ETF, walks through a fund's key details one by one.