The average opinion of the stock market is expressed through a stock market index. While following an indexing strategy the idea is to try and earn similar returns as given by a stock market index. One way to execute this strategy is by investing in constituents of a stock market index in the same proportion as their proportion in the index. But, this is a complicated strategy for individual investors as weight-ages keep changing and the investor will have to keep adjusting investments all the time. The other way is to invest in an Index fund – a mutual fund that collects money from investors and invests in stocks that make up a stock market index in the same proportion as their proportion in the index.
 
What is the logic behind an index fund?

It’s very difficult for an investor to keep beating the market. In the last two decades more than 85% of the fund managers in the United States have underperformed the S&P 500, one of the most broad-based indexes in the US. May be a Peter Lynch or a Warren Buffett can keep doing it all the time, but of the lesser mortals very few are able to do it consistently. Given this why not just ride the market? And this is the very reason that led to the innovation of an index fund.

Another reason that makes index funds attractive is their lower expense ratio. Expense ratio represents the expenses of the mutual fund expressed as a percentage of the total assets. Index funds do not require the services of high price fund managers or any sort of research. This tends to keep the expense ratios of the fund low. The Vanguard 500 index fund in the US has an expense ratio of 0.18%. The index funds in India do not have such low expense ratios but they are low vis-a-vis other funds.

All index funds do not return as much as their benchmark index. This difference between the returns from the index fund and the returns from the index is known as tracking error. This error occurs because of two reasons – the index fund may not fully track the index plus the index fund will have transaction costs to take care of.