Index Funds and Passive Investing Explained

What an index fund is

An index is a list of companies chosen by fixed rules, with a value calculated from their prices. The KSE-100 on the Pakistan Stock Exchange is an example. It groups large listed companies and gives one figure for how that group of shares is moving.

An index fund is a fund that tries to copy an index. It holds the same shares, or a close sample, in roughly the same weights. It does not try to beat the index. It tries to match it, minus its costs.

This approach is called passive investing. An active fund has a manager who picks shares and tries to do better than the market. A passive fund follows the rules of the index and changes holdings only when the index changes.

Index funds come in two common forms:

• Mutual funds: you buy and redeem units with the fund company at the daily price. See Mutual Funds.
• ETFs (exchange-traded funds): units trade on the stock exchange during market hours like shares. See What ETFs Are.

Why broad indices

A broad index spreads your money across many companies and sectors. If a single company has a bad year, it is only a small part of the whole. This is diversification.

A narrow index, such as one sector or a small group of shares, depends on fewer businesses. Its moves can be larger in both directions.

Broad does not mean safe. When the whole market falls, a broad index fund falls with it. Diversification reduces the damage from any single company. It does not remove market risk. How much of your money belongs in shares depends on your risk tolerance and time horizon and your overall asset allocation.

Cost drag: how fees compound against you

Every fund charges an annual fee, usually called the expense ratio or management fee. It is taken from the fund's assets, so you never see a bill. Instead, the fund's return is lower by that amount each year.

Because returns compound, the fee compounds too. A small yearly fee takes a bigger bite over long periods. The money lost to fees would also have grown in later years.

You can see this effect with the calculator:

How to use it for fee drag:

1. Enter your starting amount, your monthly addition and the number of years.
2. Enter an assumed yearly return. Treat it as a test figure, not a forecast.
3. Note the final value.
4. Run it again with the same inputs, but lower the return by the fund's stated fee.
5. Compare the two final values. The gap is the cost drag over your chosen period.

Try longer periods and watch the gap widen. This is why index investors pay close attention to fees. For the mechanics behind the calculation, read Compound Interest. Also remember that a return below inflation loses buying power. See Inflation and Savings.

Other costs to check in the fund documents:

• front-end or back-end loads (sales or exit charges) on some mutual funds
• broker commission and the bid-ask spread when buying ETF units
• taxes on gains and dividends

Tracking error

Tracking difference is the gap between the fund's return and the index's return over a period. Tracking error measures how much that gap varies over time. A well-run index fund keeps both small.

Common causes:

• Fees: the fund's return is lower than the index by roughly its costs.
• Cash drag: the fund keeps some cash for redemptions, and that cash does not move with shares.
• Sampling: the fund holds only some of the index shares to save costs, so its result differs.
• Rebalancing costs: when the index adds or removes companies, the fund pays to trade.
• Dividend timing: the index may assume dividends are reinvested at once, while the fund receives and invests them later.
• Liquidity: thinly traded shares can be hard to buy or sell at the index price.

When you compare index funds that follow the same index, look at the fund's past return next to the index's return in its factsheet. A consistently wide gap is a cost to you, even if the fee looks low.

A KSE-100 index fund in practice

A KSE-100 index fund aims to follow the KSE-100. Its result depends on how listed Pakistani companies perform. It is concentrated in a single country and currency, and some sectors carry a large weight in the index.

Points to check before investing:

• the fund's offering document and factsheet: index followed, fees, loads, tracking history
• whether it is a mutual fund or an ETF, and how you buy and redeem units
• Shariah-compliant versions, if that matters to you. See Islamic finance.

Regulation in Pakistan: the supervisor is Securities and Exchange Commission of Pakistan (SECP), with trading in listed securities and commodities only via SECP-licensed securities and futures brokers. Also, per the SECP, lists of licensed brokers are on the PSX and PMEX websites. For more on the market itself, see PSX basics, and for regulators, see Law and regulators.

Index funds versus index CFDs

Some platforms offer CFDs on stock indices. A CFD is a leveraged contract on price changes. You do not own any shares or fund units. Leverage can lose money fast, and holding positions overnight carries financing costs. That is a different activity from passive investing. See Stock indices for how index CFDs work.

Frequent questions

Is index investing risk-free?

No. An index fund rises and falls with its index. Market falls can be deep and can last for years.

Does a lower fee always mean a better fund?

Not by itself. Check the tracking difference as well. A low fee combined with poor tracking can still cost you.

What return should I enter in the compound calculator?

Use a test figure to compare scenarios. Run several figures, including low ones. No calculator result predicts what a fund will earn.

What is the difference between passive and active funds?

A passive fund copies an index. An active fund tries to beat it through stock picking and usually charges higher fees.

Can I buy an index fund directly on the stock exchange?

ETF units trade on the exchange through a licensed broker. Mutual fund units are bought and redeemed through the fund company or its distributors.