What is an index fund? How it works, what it costs and how to choose one

1. The short answer

An index fund is an investment fund whose only goal is to replicate an index — the MSCI World, the S&P 500, the Nasdaq-100 — as closely as possible. Nobody chooses which companies to buy: the index decides, and the fund follows it.

That is why it is called passive management. Because there is no team of analysts picking stocks, the annual cost (the TER) is a fraction of an active fund: typically between 0.05% and 0.30% a year, against 1% to 2% for many actively managed funds sold by banks.

2. How it works inside

When you put money in, the manager buys the index constituents in their index weights. If Apple is 5% of the index, roughly 5% of your money ends up in Apple. When the index changes — a company enters, another leaves — the fund adjusts.

There are two ways to replicate. Physical replication buys the actual shares (all of them, or a representative sample). Synthetic replication uses a swap with a bank that pays the index return. Both are regulated under UCITS rules in Europe; physical is the more common choice among individual investors because it is easier to understand.

Returns also come in two flavours: accumulating share classes reinvest dividends automatically, distributing ones pay them out to you.

3. Why a 1% difference in cost is not small

Costs are the one part of the return you know in advance. They are charged every year on everything you have, so they compound against you exactly as returns compound in your favour. An illustrative example with €10,000 invested once and a hypothetical 6% gross annual return:

"Lost to costs" is measured against the same 6% with zero costs (€32,071). Hypothetical figures, rounded; they are not a forecast of any fund.

Past a certain point the argument is not "index funds are better". It is that whatever an active fund does, it has to beat the index by its extra cost every single year just to break even — and the long-running S&P SPIVA scorecards show most active funds fail to do so over 10 to 15 years.

4. The indices almost everyone uses

Choosing an index fund is mostly choosing an index. Three families concentrate most of the money of European individual investors, and each answers a different question:

• MSCI World: about 1,300 large and mid companies in 23 developed countries. The default "whole developed market" choice.
• S&P 500: the 500 largest US companies. More concentrated in one country, and the cheapest index to track.
• Nasdaq-100: the 100 largest non-financial companies on the Nasdaq exchange. A concentrated bet on large-cap technology.

Our fund catalogue compares the main ETFs and index funds for each of them, with their ISIN, TER and replication method.

5. Index fund or index ETF?

An ETF is an index fund that trades on a stock exchange. The investment inside can be identical; what changes is how you buy it, what it costs to hold and — in Spain — how it is taxed when you move money between funds. We break it down in ETF vs index fund: the differences that actually matter.

6. Keep it next to the rest of your money

An index fund is designed to be boring, and that is the point: the hard part is not choosing it, it is leaving it alone for years. Seeing it as a percentage of your total net worth — not as a red or green number in the broker app — makes that much easier.

This is educational content, not financial advice: it explains concepts so you can make your own decisions, and it does not recommend any specific product or allocation.