What Makes a Good Index Fund?
Indexes have changed a lot over the past century. What was once state-of-the-art is now antiquated. The first indexes used information that was available, not what was best for building a portfolio. Modern-day indexes have evolved over time to keep costs down and provide a better investment experience.
A Brief History of Indexes
The first indexes were designed merely to gauge the health of the economy. They were simple. Charles Dow started publishing the Dow Jones Transportation Average, or DJTA, in 1884. It was the first market index, composed mainly of railroad stocks. Twelve years later, Dow created the more recognizable Dow Jones Industrial Average, or DJIA, which covered several industries and was better suited to be a barometer for the US economy.
At the time, public companies disclosed little information, the SEC didn’t exist, and insider trading was legal. Share prices were available and transmitted through mechanical tickers: machines that printed out share prices using telegraph technology. Consequently, Dow’s first indexes relied (and still rely) on share prices to weight its components. Price weighting utilizes the share price of a stock, not its market capitalization, to determine its weighting in a portfolio; stocks with higher share prices are given more weight even if they are smaller companies in terms of market cap.
Price weighting was innovative in Dow’s day, but it’s doubtful he anticipated investors would one day copy the index to manage their portfolios. Using share price alone to determine a stock’s weighting in investors’ portfolios has shortcomings. Imagine a price-weighted portfolio that holds only Berkshire Hathaway A shares BRK. A and Nvidia NVDA. As of January 2025, the portfolio would contain more than 99% Berkshire and less than 1% Nvidia, even though Nvidia’s market cap is 3 times larger.
Market-Cap Weighting: A Representative Slice
Market-cap-weighted indexes construct portfolios that more accurately represent the stock market. The first established and most well-known is the S&P 500. At the index’s inception in 1957, the SEC had already been established and publicly traded companies were now required to provide financial information, including their number of shares outstanding, making it easy to calculate market caps.
The largest stocks by market cap have the highest allocations in the index. Over the years investors witnessed most mutual funds underperforming market indexes, but they didn’t have a way to invest in the indexes. Jack Bogle changed that for retail investors. In 1976 Vanguard created a mutual fund that tracked the S&P 500. It had mixed views initially, but it has grown its assets to over 1.3 trillion dollars, as of year-end 2024.
Indexes Tracked Most Heavily by Funds
I surveyed over 2,500 US open-ended funds that track indexes, including both mutual funds and exchange-traded funds. The top two indexes as measured by the amount of money tracking them were the S&P 500 and the CRSP US Total Market Index. Over a third of all the money in the analysis mimicked one of those two.
The S&P 500 topped the charts for both the number of funds and the total amount of money tracking its portfolio. Exhibit 2 ranks the top indexes based on the number of funds tracking them.
Despite the popularity of market-cap-weighted index funds, some fund companies still offer funds that track the DJIA. The index’s performance is acceptable, but the thinking behind its construction is flawed. Share-price weighting worked 100 years ago when other options were limited. But they don’t accurately reflect the value of a company by themselves. Indexes, like many things, evolve and improve over time. Henry Ford created his first car, the quadricycle, in 1896. It may have been cutting-edge at the time, but cars have improved a lot since then. I wouldn’t rely on it to reach my destination today.
The Devil Is in the Details for Index Investing
When it comes to selecting an index, the devil is in the details. Not all indexes are well suited for replication. For example, the Wilshire 5000 Index aims to capture the entire US equity market. Stocks are eligible if they trade on a major exchange, but the index does not require the stocks to be easily traded. So it can hold smaller stocks that can be expensive to transact. Funds that track the Wilshire 5000 Index don’t copy it stock for stock. Instead, they use representative sampling, holding only a portion of the index’s portfolio, to avoid such stocks and manage trading costs.
The S&P 500’s construction lends itself well to full replication: copying an index’s holdings and weightings exactly. Selecting the largest, most easily traded stocks in the US stock market allows funds to track an index with the least amount of friction.
But the S&P 500 has a quirk. Companies must have positive earnings, as defined by generally accepted accounting principles, to make the cut. This profitability screen has excluded some big names. Tesla TSLA wasn’t included in the index until December 2020 because of its negative earnings, even though it was widely traded and had grown large enough for inclusion several years earlier. Other large-cap benchmarks without a profitability screen, like the Russell 1000 Index, held Tesla for a decade before it made its way into the S&P 500.
The Nasdaq 100 Index is a peculiar one. Most indexes include stocks from all the major exchanges in their category. The Nasdaq 100 does not: It selects only stocks that trade on Nasdaq. Excluding stocks from other major exchanges is an arbitrary choice since their listing exchange doesn’t change their growth prospects. The index’s relatively high recent returns can be attributed to its heavy allocation to technology stocks.
The Power of Index Funds
ETFs have mainly been a vehicle for index funds. At the end of 2024, more than 90% of the money wrapped up in US ETFs was tracking an index. Ten years ago, it was 99%.
One of index funds’ biggest advantages over actively managed funds is lower fees. Combine that with index funds’ lower turnover and trading costs, and you have a strong cost advantage.
As shown below, fees tend to be razor-thin for index funds. For reference, SPDR S&P 500 ETF Trust’s SPY 0.095% fee is one eighth the cost of the average fund in the large-blend Morningstar Category, and cheaper options exist. Invesco QQQ Trust QQQ has the highest fee in the table, but its fee is one fourth that of the average large-growth fund.
The Tortoise, Not the Hare
Index funds lack the high potential short-term upside of actively managed funds, but their relative safety and low costs make them hard to beat in the long run. Buying an actively managed fund is no guarantee of outperformance. If anything, active managers are quite likely to underperform the market in categories tied to large, highly traded markets, such as large-cap US stocks.
Successful Investing in Index Funds
When in doubt, investing in a low-cost market-cap-weighted index fund with broad reach should deliver solid results. A good starting point in selecting the right fund is to review its fee and the characteristics of the index it tracks.
In general, indexes should capture most of the market to maximize the benefit of their cost advantage. For example, the S&P 500 typically holds around 80% of the total market cap of US companies. Even more comprehensive, the CRSP US Total Market Index holds nearly all US stocks, granted they pass an investability screen. Once comfortable with an index, investors can look for the cheapest funds that track it to maximize their returns.
