What is an index fund?
An index fund is a type of mutual fund or ETF with a single job: to follow a particular stock index. It buys the companies in the index, and the bigger a company’s weight in the index, the bigger its share in the fund. The manager does not judge which companies are good or bad.
The idea is not new. In 1976 in the US, John Bogle launched a fund for ordinary investors that followed the S&P 500 index. The target was $150 million, but it raised only $11.3 million. Funds like it later became very popular worldwide.
Imagine copying your mother’s biryani recipe exactly: as much rice, as much meat, as much spice, in the same proportions. You change nothing to suit yourself. The taste will be very close to hers, but because the pot and stove are different, it won’t be exactly the same. An index fund copies the index’s “recipe” in just this way.
Why it matters to an investor
- To know what you are buying: an index fund means owning all the index’s companies by their weights. If a few big companies dominate the index, a big part of your money goes there too.
- To understand costs: an index pays no fees, but a fund does. So a fund’s return is usually a little below the index’s.
- To compare funds: two funds following the same index differ mainly in cost and in how closely they follow it.
- To keep expectations right: an index fund does not try to beat the index. When the index falls, the fund falls too; that is by design.
How a fund follows an index
The simplest method is “full replication”: buying every share in the index at exactly its index weight. If a company makes up 8% of the index, about 8% of the fund’s money goes into it. When an index has very many shares, or some trade thinly, a fund may use “sampling”: buying a subset that behaves much like the whole index instead of all of them.
The index itself changes over time. The stock exchange reviews it regularly under set rules: some companies drop out, new ones come in, weights change. The index fund must then buy and sell to match, and when investors put money in or take it out, the fund buys or sells in the same proportions.
Why a fund never matches its index exactly
An index is a calculation on paper; a fund has to trade with real money in a real market. The gap between the index’s return and the fund’s return is called the tracking difference, and how much that gap swings over time is measured by tracking error.
- Fees and expenses: management fees and other costs come out of the fund’s assets every year.
- Trading costs: buying and selling when the index changes or money moves in and out costs brokerage and other charges.
- Cash: a fund keeps some cash to pay investors who leave. When the market rises, that cash lags behind.
- Timing: the fund may not be able to trade at the exact moment a dividend or index change is counted in the index.
The situation in Bangladesh
Index-based funds have moved very slowly in Bangladesh. In 2022 the DSE said BSEC had agreed in principle to ETFs investing mainly in the DS30 index. But the first ETF later approved in the country was manager-run rather than index-tracking, and in 2024 it still had not launched because of weak investor interest. When a new fund appears, check the latest information from BSEC and the stock exchanges.
Worked example
- Say an index has three companies: A weighs 50%, B 30% and C 20%. If Tk 10 crore comes into the fund, the manager buys Tk 5 crore of A, Tk 3 crore of B and Tk 2 crore of C.
- Over a year the index rises 10%. On paper, Tk 1,00,000 would become Tk 1,10,000.
- The fund’s yearly costs are 0.5%, and trading costs and cash hold it back another 0.3%. The fund returns about 9.2%: Tk 1,00,000 becomes about Tk 1,09,200.
Result: the fund is very close to the index, but about Tk 800 behind. That 0.8% is the tracking difference. Of two funds following the same index, the one with the smaller gap is following it more closely. The numbers are only an example.
Common mistakes
- Assuming an index fund will return exactly what the index does. Costs and trading usually make it a little less.
- Assuming without checking that “index fund” means money spread evenly across many companies. If a few companies dominate the index, they dominate the fund too.
- Judging a fund by its name alone. Which index it follows, and whether it really follows one at all, is in the prospectus.
- Ignoring costs when comparing two funds on the same index. When they buy the same things, the difference is almost all cost.
An index fund copies the index’s recipe: a return close to the index, risk like the index, and the gap between them is mostly cost.