Index mutual funds

An index mutual fund works in much the same way as any other mutual fund. The fund sells shares to investors and uses the money it raises to purchase a portfolio of investments — called the fund’s underlying securities — to meet its investment objective. Fund investors don’t own the fund’s underlying securities directly, but instead own shares of the fund, and receive earnings on its investments in the form of distributions.

Types of index funds

Most index funds are full replication funds, which means they purchase all of the securities in direct proportion to their weighting in the index. So, for instance, a full replication fund tracking the market capitalization- weighted S&P 500 would own shares in all 500 stocks, but it would own more shares of the stocks with the highest capitalizations and fewer shares of those with the smallest.

However, in some cases a fund may use computer modeling to identify representative securities in the index based on their financial characteristics and market behavior and purchase only a sample of the index. A fund might use this strategy, called optimization, if the index is very large (and therefore too expensive to fully replicate), its securities trade infrequently, or if for regulatory or other reasons full replication is impractical. An example of a fund that uses this strategy might be one managed against the Russell 2000 benchmark. With 2000 stocks in the index, it is easier and cheaper to replicate with a sampling of the stocks.

Index tracking and tracking errors

The goal of a replication fund is to produce the same returns that you would get if you owned all of the stocks in the index. But because of transactions, operations, and other costs, fund net asset values (NAV), or cost of shares, always slightly lag the returns of the underlying index. The spread between the fund NAV and the index return is called the tracking error, and the goal is to keep the spread as narrow as possible.

In fact, funds that track the same index will vary in performance on account of differences in replication technique and expense ratios. The higher the expense ratio, the lower your return will be, even when the underlying investments are the same.

It’s a good idea to be on the lookout for replication funds with high expense ratios equivalent to those of actively managed funds. You probably don’t want to overpay for passive management, since fund expenses will chip away at your investment return.

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