What a market index is
A market index is a list of securities selected according to a set of rules — the S&P 500 tracks 500 large US companies by market capitalisation, the FTSE 100 tracks the 100 largest UK-listed companies, and the MSCI World tracks approximately 1,500 companies across 23 developed markets. An index fund buys a proportional slice of everything in the index. When Apple rises 10%, an S&P 500 index fund rises by roughly Apple’s weight in the index (about 7%) times 10%, plus movements from all the other 499 companies.
Why index funds win: the cost advantage
The average actively managed fund charges an ongoing expense ratio of 0.7–1.5% per year. A typical index fund charges 0.03–0.20% per year. That gap compounds devastatingly over time. A 1% annual fee drag over 30 years on a £100,000 portfolio reduces the final value by approximately £75,000 — money that went to the fund manager rather than to you. This cost disadvantage is why, according to the S&P SPIVA report, around 90% of active large-cap funds underperform their benchmark over 20 years.
Index funds vs ETFs
An index fund and an ETF (exchange-traded fund) are closely related but not identical. A traditional index fund is priced once daily and bought directly from the fund company. An ETF tracking the same index trades on a stock exchange throughout the day like a share. For most long-term investors, the differences are minor — both offer the same market exposure at similarly low costs. ETFs have slightly more flexibility (intraday trading, options) and may be more tax-efficient in some jurisdictions; mutual index funds may have lower minimum investment thresholds.
Criticisms of index investing
The main critique of passive investing is that it doesn’t think. When a company becomes enormously overvalued, the index buys more of it (because its market cap grows). Passive funds also own every company in the index regardless of quality — the outstanding businesses alongside the mediocre ones. A related concern is that as passive investing has grown, it may have distorted price discovery. These are legitimate intellectual criticisms. They don’t change the empirical reality that most active managers still fail to overcome the cost disadvantage.
“Don’t look for the needle in the haystack. Just buy the haystack.” — Jack Bogle, founder of Vanguard
What this means for you
For the vast majority of retail investors, a globally diversified index fund (such as a FTSE Global All Cap fund or a total world stock market ETF) held in a tax-advantaged account (ISA, SIPP, 401(k)) with regular contributions is the single highest-expected-value investing approach available. It requires no stock-picking skill, minimal time, and outperforms most professional fund managers after costs. The only reliable way to do worse is to pay high fees, trade frequently, or try to time the market.