Introduction
Index investing is a strategy that aims to follow the performance of a market index rather than select individual securities expected to outperform it. Investors typically use index mutual funds or exchange-traded funds for this purpose.
The approach is popular because one fund can provide exposure to many securities, often at relatively low cost. It also reduces the need to continually research and trade individual companies.
However, index investing does not eliminate risk. An index fund follows its market both upward and downward, and different indexes can provide very different exposures.
How index investing works
A market index is a rules-based measure of a group of securities. An index might represent large U.S. companies, the total stock market, international stocks, bonds, or a specific market segment.
An index fund attempts to track the performance of its chosen benchmark. Depending on the fund, it may hold every security in the index or use a representative sample.
Investors receive the return of the fund after expenses and any tracking differences. Therefore, an index fund’s return will usually be close to, but not exactly the same as, the published index return.
Why investors use index funds
Diversification
A broad index fund can hold hundreds or thousands of securities, reducing dependence on the results of a single company.
Low costs
Many index funds have relatively low expense ratios because they follow a rules-based benchmark rather than paying managers to continually select securities.
Simplicity
Broad funds can make it easier to build market exposure without analyzing every company in the portfolio.
Transparency
Index rules and holdings are often easier to understand because the fund follows a defined benchmark.
Index funds and index ETFs
Index investing can be implemented through mutual funds or index ETFs. Both can follow the same or similar market benchmarks.
The main differences come from the fund structure. ETFs trade on exchanges during the day, while traditional mutual funds generally transact at a price calculated after the market closes.
Investors should compare costs, trading features, minimum investments, taxes, and convenience rather than assuming one structure is always better.
Not all indexes are broadly diversified
The word index can create the impression that a fund automatically owns the entire market. In reality, indexes can be very broad or extremely narrow.
A total-market index may hold thousands of companies, while a sector or thematic index may focus on a small part of the economy. Weighting methods also differ. Some indexes weight companies by market capitalization, while others use equal weighting or other rules.
Therefore, investors need to understand what an index actually measures before using a fund that tracks it.
Market-cap weighting
Many major stock indexes use market-capitalization weighting. Under this method, companies with larger stock-market values receive larger weights in the index.
As a result, the largest companies can have a meaningful effect on index performance. If a small group of very large stocks rises or falls sharply, a market-cap-weighted fund can move with them.
This approach automatically adjusts as company values change, but it can also create concentration in the market’s largest companies or sectors.
Index investing versus active investing
| Characteristic | Index investing | Active investing |
|---|---|---|
| Main objective | Track a benchmark | Make investment choices that may outperform or meet another objective |
| Security selection | Driven mainly by index rules | Driven by manager or investor decisions |
| Costs | Often relatively low | Can be higher, depending on the strategy |
| Market exposure | Depends on the chosen index | Depends on selected holdings |
| Underperformance risk | Generally trails the index slightly after costs | Can outperform or underperform the benchmark |
Costs and tracking difference
Even small costs matter over long periods because they reduce the return investors keep. Expense ratios are one of the most visible costs of index funds.
Tracking difference measures how the fund’s actual performance differs from the index it follows. Expenses, trading costs, taxes, sampling, and portfolio management can all contribute to the gap.
For ETFs, investors may also encounter bid-ask spreads and brokerage-related trading costs.
Risks of index investing
Index funds still carry the risks of the securities they own. A stock index can experience a severe bear market, while a bond index can lose value when interest rates or credit conditions change.
Index investors also accept the holdings selected by the benchmark rules. If a company becomes a large part of the index, the fund generally owns a correspondingly large position even if its valuation appears high.
Finally, narrow indexes can create concentration risk. Diversification depends on the actual holdings, not simply on whether a product has the word index in its name.
Combining index investing with other strategies
Index investing can work naturally with buy and hold and dollar-cost averaging. For example, an investor might make regular purchases of a broad index fund and hold those shares for many years.
An index fund can also form the core of a portfolio while smaller positions follow active, income, growth, or value strategies.
As with other core investing strategies, the appropriate role depends on the investor’s goals, time horizon, and risk profile.
Key takeaways
- Index investing aims to track a market benchmark rather than select individual securities expected to outperform it.
- Investors commonly use index mutual funds and ETFs to implement the strategy.
- Broad index funds can provide substantial diversification at relatively low cost.
- Not every index is broad, and narrow or concentrated indexes can carry significant risk.
- Fund expenses and tracking differences reduce returns relative to the published index.
- Index investing still exposes investors to market declines and the risks of the securities in the benchmark.