How indices are constructed
Most major indices are market-capitalisation weighted: each company’s weight in the index equals its market cap as a proportion of the total. Apple is the largest constituent of the S&P 500 because it has the largest market cap — so a 1% move in Apple moves the index more than a 1% move in a smaller company. Price-weighted indices (like the Dow Jones Industrial Average) weight by share price, which is less economically meaningful and rarely used in modern index construction. Some indices are equal-weighted (each company has the same weight regardless of size) or factor-weighted (overweighting based on value, quality, or other characteristics — the basis of "smart beta" ETFs). The methodology matters: two indices covering the same market can behave meaningfully differently depending on their construction rules.
Why indices became the default benchmark
Decades of academic research and practical evidence have established that most active fund managers — who charge higher fees in exchange for attempting to beat the index — fail to do so consistently after fees. The S&P SPIVA report, published annually, consistently shows that roughly 85–90% of active US equity funds underperform the S&P 500 over 15-year periods. This finding is not unique to the US — it holds across markets globally. The rational response: if most professionals cannot beat the market consistently, individual investors are unlikely to do so either, and should instead capture market returns at the lowest possible cost by owning index funds.
What this means for you
When you invest in an index fund or ETF tracking the FTSE All-World, you own tiny fractions of thousands of companies across dozens of countries. When any of those companies grows — Microsoft, Nestlé, Samsung, HSBC — your fund grows with it proportionally. The cost is typically 0.1–0.2% per year in charges (OCF), compared to 0.8–1.5% for actively managed funds. Over 30 years, that fee difference compounded can represent hundreds of thousands of pounds. Vanguard, BlackRock’s iShares, and Fidelity’s range all offer low-cost global index funds widely available through UK platforms including Vanguard Investor, Hargreaves Lansdown, and Freetrade.