Index Funds: How They Work and Which to Own

How tracking works

The fund buys the index constituents and rebalances as the index changes. There is no forecasting and no discretion, which is why running costs are a fraction of an active fund's. Tracking difference — the gap between the fund's return and the index — is the quality measure to check, and on large broad funds it is typically tiny.

Because there is no manager view to be wrong, index funds also avoid the largest risk in active investing: paying a premium for underperformance and only discovering it after a decade.

Why the expense ratio dominates

Fees compound in the same way returns do. A 1% annual expense ratio instead of 0.05% on a portfolio held for thirty years consumes a substantial share of the final balance, without changing the risk taken.

Broad index funds are now available at single-digit basis points. Any fund charging materially more should have a specific reason, and 'the manager has a strong track record' is rarely a good enough one.

ETF or mutual fund

Both wrappers can track the same index at almost the same cost, and the differences are mostly mechanical.

• ETFs trade intraday at market price; mutual funds trade once daily at net asset value.
• ETFs are usually more tax-efficient in a taxable account thanks to in-kind redemptions.
• Mutual funds allow exact dollar amounts and automatic recurring investments more easily.
• Inside a 401(k) or IRA the tax-efficiency advantage disappears — pick on cost and availability.

How many funds you need

Two or three is usually enough: a total US stock market fund, a total international stock fund, and a total bond fund weighted to your time horizon. A single target-date fund does all of that automatically and rebalances for you.

Adding sector funds, factor tilts and thematic products increases complexity and cost without reliably improving returns. If you cannot state in one sentence why a fund is in the portfolio, it should not be.