What is an Index Fund?

What an index and a benchmark represent

A market index is a defined, rules-based list of securities — such as a set of company shares — combined into a single number using a published methodology, and used as a reference point for how a segment of the market is doing. Exchanges and index providers publish these indices and the rules behind them.

A benchmark is simply the index a particular fund has chosen to measure itself against — or, in an index fund's case, the index it aims to track. Whether a fund is actively or passively managed, its benchmark tells you what part of the market it is being judged against.

How an index fund tries to track its benchmark

An index fund's mandate is to replicate its chosen index as closely as practical — generally by holding the same securities in proportions close to their weight in the index, and adjusting the portfolio when the index itself changes its own composition.

This is a mechanical, rules-based process rather than a judgement call about which securities look attractive. The fund manager's role in an index fund is largely about replicating the index accurately and cost-efficiently, not about choosing which securities to hold.

Active vs passive: what the difference actually means

An actively managed fund's manager selects securities with the aim of outperforming a benchmark, based on research and judgement, and the fund's holdings can differ substantially from the index. An index fund does not attempt this — its stated objective is to track the index, not exceed it.

Neither approach removes the underlying market risk. An actively managed equity fund and an index equity fund tracking the same broad market are both still equity investments, and both can rise or fall with that market — passive management changes how the fund is run, not the fact that it remains a market-linked investment.

Tracking difference and tracking error — two different things

An index fund rarely matches its index's return exactly, because of costs such as the expense ratio, transaction costs when the portfolio is adjusted, and cash held for redemptions. Tracking difference is the gap between the fund's actual return and the index's return over a given period — a straightforward, after-the-fact comparison of the two return figures.

Tracking error is a different measure: it describes how much the fund's period-to-period returns have varied relative to the index's own returns over time — a measure of consistency, not of the size of the gap itself. A fund can show a small overall tracking difference but still have a higher tracking error, if its returns moved above and below the index along the way rather than tracking it smoothly period after period.

The two terms are not interchangeable, and comparing index funds on only one of them gives an incomplete picture. A smaller tracking difference and a lower tracking error both matter, for different reasons.

What expense ratio has to do with tracking

Because an index fund's stated objective is to match its index rather than try to beat it, cost has an outsized effect on the outcome. An index fund's expense ratio is one of the more direct drags on how closely it can track its benchmark, since the index itself carries no cost of its own. The Academy's article on expense ratio covers this cost in more general terms.

This is also why index funds and other passively managed funds generally carry lower expense ratios than actively managed schemes in the same broad category — they are cheaper to run, since there is no research team selecting individual securities — though the specific ratio still varies from fund to fund and is worth comparing directly rather than assumed.

What to look at before comparing index funds

The index being tracked matters first — two index funds tracking different indices are not really being compared on tracking quality at all, since they are following different things. Beyond that, the expense ratio and the fund's own tracking-difference and tracking-error history are the practical points of comparison, alongside how the fund is actually structured — a mutual fund bought and redeemed at NAV, which the Academy's article comparing an index fund and an ETF covers in more depth.

None of this changes the fact that an index fund remains a market-linked investment. A lower cost or a smaller tracking difference does not mean lower market risk — it means the fund is doing a more precise job of delivering whatever the index itself does, for better or worse.