According to the SEC's investor bulletin, an index fund tries to earn roughly what its index earns by owning the companies in it, and because nobody is paid to choose securities, spending on research analysts and frequent trading largely falls away. Those savings are the product. Over long periods a fund that charges less keeps more of the market's return for its holders, and fees work like compound interest in reverse, shrinking the balance a little more each year. The same bulletin is plain about risk: the fund carries whatever risks the index carries, so a falling market means a falling fund, with no manager tasked with stepping aside.
Index funds are the everyday tool for putting an asset allocation into practice with broad diversification inside each bucket, which is why they run through investing and portfolio management and personal finance and planning. Weighting by market capitalisation has one consequence: the largest companies take the largest share, so a popular index can grow more concentrated as its leaders rise. Owning the index is still owning that concentration, which is worth checking against the rest of the portfolio.
What to check before choosing one
- The index itself: which securities it includes, how they are weighted, and how often the list is revised.
- Tracking difference: how far the fund's return has trailed or led the index once costs are counted.
- Costs: the fund's ongoing charges, its trading costs, and any platform fees charged on top.
- Wrapper: a mutual fund is bought and sold at its end-of-day value, while an exchange-traded fund trades on an exchange during the day.