Index Funds Explained for Beginners

The need of index funds becomes obvious once an investor concludes that stock-picking won’t work for them.

And history shows that index funds may be the best way to build long-term wealth.

Not by beating the market, not by timing the market. It’s done by matching the market through an index.

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Index Funds

An index fund is a special type of an investment fund that aims to track the performance of an index.

Unlike the actively managed funds, which try to outperform an index, the passively managed funds are usually tracking an index. That means that their performance will always be in line with the index’s performance. This is achieved by buying the securities of the particular index.

For example, if an index fund tracks the S&P 500, it would ideally have holdings in all companies from the index and in the same proportion.

Tracking Error

The tracking may not be perfect, so there may be some (small) differences in the performance of an index fund and the index itself.

This is called a tracking error.

The reasons for this difference are various and include:

Using a representative sample of the index’s components instead of all the securities
Using a slightly different weighing than the index itself
The fund’s expense ratio (higher fees will make your portfolio smaller and thus performing worse than the benchmark)

Index Fund Example

On the picture you can see an example of the performance of an index and a fund for 5 days (up) and 6 months (down).

On the left side we have the S&P 500 index itself and on the right side it’s VFINX – Vanguard’s S&P 500 index fund.

Performance comparison of S&P 500 (left) and VFINX (right)

The similarity of the charts illustrates to which extend a fund can track its benchmark’s performance.

However, on the 5 day screenshot, you can see a difference. The index is updated continuously, but the fund’s value is updated daily.

The reason for this is that a fund’s price is determined once per day, after the market closes.

The fund’s price is called its Net Asset Value (NAV).

It is calculated by the last quoted daily price of all the fund’s holdings minus the fund’s expenses, divided by the number of outstanding shares.

Difference from Stocks

The funds’ prices are determined once per day.

Also, the fund executes orders once per day. This means that investor’s can’t day trade using funds.

Some people consider this a disadvantage and some consider it an advantage. I consider it neither.

This is how mutual funds work and the investor’s decisions should originate from his strategy, not from operational restrictions.

Investing in Index Funds

Investing in index funds is usually as simple as opening an online account and depositing money.

But before putting your money in an index fund, there’s some preparation you’d need to do.

Most importantly, you should know which market (index) you want to use as a benchmark for your portfolio. Only then comes the part of further research, comparing costs, etc.

Real Life Example of (not) Choosing a Fund

When I was starting my investment journey, I found an index fund that tracked the market I was interested in.

Their website was intuitive, communication clear, so I was almost convinced to invest.

However, it had >0.2% yearly fee plus entry and exit fees. Since it was only a tracker fund, I could achieve the same performance by simply buying an ETF that tracks the same index.

Of course, we haven’t covered ETFs yet, so don’t jump to any conclusions. Subscribe below to get notified when I publish the dedicated post.

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