What is an index fund?

An investment fund is a legal entity that collects money from multiple investors and uses it to follow an investment strategy. There are countless investment strategies that can be used by a fund – from investing in specific asset classes (e.g. bonds, gold, companies) to investing in specific geographies (e.g. China, Europe). An investment fund employs investment managers to carry out the fund’s investment strategy. An investment fund charges a fee to investors and distributes the remaining earnings of the fund to its investors.

For the purposes of this article there are 2 types of funds in regards to how the investment strategy is applied: active funds and passive funds.

In active funds investment managers have the ability to decide how they implement the investment strategy in order to deliver superior returns to the investors. Achieving superior returns means the fund has to deliver better returns than the overall market. The overall market is measured by something called the benchmark.

For example, the Vanguard Global Equity Fund is meant to invest in companies all over the world. Its investment managers decide which companies to buy/sell, when to buy/sell them and in which quantities. The fund’s benchmark – what it has to outperform – is the FTSE All World Index, a popular way of measure the global stock market. You can figure out that the fund is active by reading its KIID or its Morningstar “investment objective” section – you won’t see the word “index” mentioned. The fund’s Morningstar page will also provide information on the fund’s benchmark.

In passive funds (also known as index funds) investment managers can’t make decisions on how the investment strategy is implemented. They simply have to follow (i.e. track) the performance of the whole market or sector, hence the term passive. The behavior of the market is described by something called the index. An index will outline which companies are to be invested in and in which relative proportion. These indexes are usually the benchmarks upon which an active fund’s performance is measured. An index fund will generally give you the performance of the market, it won’t allow you to outperform or underperform the market.

The Vanguard FTSE Global All Cap Index Fund is meant to invest in companies all over the world but it achieves that by tracking the FTSE Global All Cap Index. The job of its investment managers is to try to follow the index in the most accurate way possible. You can figure out that the fund is passive by reading its KIID or its Morningstar “investment objective” section – you will see the word “index” mentioned.

Index funds tend to have lower fees than active funds. Index funds also tend to have better long term performance than active funds.

For the purposes of this article an investment fund can be (legally) structured in two ways: mutual fund or Exchange Traded Fund (ETF).

Mutual funds constitute the oldest fund structure. Shares for a mutual fund are usually bought directly from the fund company. Mutual fund shares may also be bought through a broker or bank but they are only acting as a distributor for this direct relationship between the fund company and the investor. The Vanguard FTSE Global All Cap Index Fund is an example of a mutual fund.

An ETF can only be bought on a stock exchange through a stock broker. When you buy an ETF you are buying your shares from other investors which are selling them, you are not buying them from the fund company. The Vanguard FTSE All-World UCITS ETF is an example of an ETF.

The name of the fund usually tells you if the fund is a mutual fund or ETF. ETFs usually have the word “ETF” as part of the fund’s name. Additionally you can only find ETFs on justETF while on Morningstar you will find both ETFs and mutual funds.

You can buy both active and passive funds as mutual funds or ETFs.