How ETFs and index funds work: the basics of passive investing and diversification

An index fund is an investment fund that tries to track a market benchmark (an index) — for example the S&P 500, which covers 500 large US companies. Its essence is “passive” investing: the fund manager does not pick which shares to buy but simply copies the whole index. This differs from “active” management, where an expert tries to beat the market by selecting stocks. (Source: U.S. SEC, Investor.gov — Index Funds.)

Where the index fund came from

The first index fund aimed at the general public was launched by John C. Bogle at Vanguard on 31 August 1976 as the “First Index Investment Trust.” It initially raised only about $11 million — Bogle later called it a failure. Today the passive index strategy is one of the largest investment approaches in the world. (Source: Vanguard — “Indexing since 1976.”)

What an ETF is and how it differs from an index fund

An ETF (Exchange-Traded Fund) also usually tracks an index, but unlike a traditional index fund it trades like a stock at any time during the trading day. The first US ETF — the SPDR tracking the S&P 500 (ticker: SPY) — was launched by State Street on 22 January 1993 and is today one of the largest ETFs in the world. A traditional (open-end) index fund, by contrast, is bought once a day at the price set after the market closes. (Source: State Street — SPY; U.S. SEC — ETFs.)

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Diversification: spreading the risk

The main advantage of an index fund or ETF is diversification. When you buy one share, your money is spread across dozens or hundreds of companies, so the poor result of one company or sector does not hit your whole savings hard. Betting on a single stock, by contrast, can lead to large losses if that company collapses. (Source: U.S. SEC, Investor.gov — Mutual Funds and ETFs.)

The expense ratio: a small percentage, a big difference

Every fund charges an annual management fee — the “expense ratio,” given as a percentage. In the US market the median expense ratio is about 0.58% for ETFs and about 0.90% for traditional funds. That looks small, but over decades it compounds and meaningfully reduces final returns, because each year’s fee eats into compounding growth. This is why low-cost, broad index funds are often preferred. (Source: U.S. SEC — How Fees and Expenses Affect Your Investment Portfolio.)

Risks: no guarantee

ETFs and index funds are not risk-free. They are subject to market risk: if the index falls, the fund falls too, and the holding is not insured the way a bank deposit is (e.g. the FDIC in the US). Note also that some ETFs are tied to a narrow sector or a foreign currency; “leveraged” and “inverse” ETFs are far riskier and are not meant to be held long term. Always read the fund’s prospectus. (Source: U.S. SEC, Investor.gov — Exchange-Traded Funds.)

Is there a halal (Shariah-compliant) option?

Broad conventional index funds may include interest-based (riba) banks or other non-Shariah-compliant businesses. For this reason Shariah-compliant indices and ETFs exist: they screen out interest-based finance, alcohol, gambling and similar sectors (for example the S&P Shariah indices calculated by S&P Dow Jones Indices). When choosing such a product, it is advisable to check that it is approved by a Shariah board. (Source: S&P Dow Jones Indices — S&P Shariah Indices.)

Conclusion

Index funds and ETFs are a way to track the market as a whole — cheaply and in a diversified way — rather than picking it. Their strength is passivity, low cost and breadth; their weakness is that they fall with the market. This article is general information, not financial advice — make investment decisions in light of your own situation and, if needed, with a licensed adviser.