Index investing: what you’re actually buying

First, what is an index?

An index is basically a list of investments put together using a set of rules. The rules decide what gets included and how much each holding counts. An Australian share index can look very different from a worldwide one.

You cannot usually buy an index directly. A fund may instead aim to replicate or closely track it.

How index funds work

An index fund generally tries to match the returns of a specified benchmark before fees and tracking differences. It may own the securities in that index directly or use another permitted implementation approach.

Because the aim is to follow a benchmark rather than select individual winners, many index products have relatively transparent rules. Their level of diversification, risk and fees can still vary widely.

Not all indices are broad

A fund tracking a small group of technology companies is very different from one tracking a broad global market. An index can be concentrated by company size, sector, country or other rules. Look at the benchmark methodology and holdings rather than relying on the word “index”.

Tracking and other differences

A fund’s result can differ from the index because of fees, trading costs, taxes, cash holdings, implementation and timing. Tracking difference is one useful measure to examine alongside the fund’s stated management fees and costs.

Market-cap weighting is one design choice

Some indices weight companies according to their market capitalisation, meaning companies with greater market value generally receive greater weight. Others apply equal weighting, fundamental measures or more specialised rules. The benchmark design changes the investment exposure, even when both funds are called index funds.

A market-cap-weighted fund may naturally become more concentrated in the companies whose prices have risen most. That isn't necessarily an error; it is a consequence of the index methodology worth understanding.

Why “passive” still requires choices

Choosing which index to track, whether to cover a region or the world, how the index handles emerging markets and whether currency exposure is hedged are all important choices. The fund manager may be following the index mechanically, but the benchmark itself defines what enters the portfolio.

Passive management can reduce the need to forecast individual winners. It cannot remove uncertainty about market returns, fund structure or the investor’s own objectives.

How to check what an index actually tracks

Find the index name on an ETF's official fact sheet. Look up the index provider's methodology: which countries and company sizes qualify, how holdings are weighted and when it rebalances. For example, an index of the largest Australian companies will have a very different mix from one covering global shares.

Tracking an index can reduce the need to pick individual companies, but it doesn't remove the need to choose an appropriate market or understand the risks.