Index Funds Are Fake: Here’s The Truth On How They Work

When it comes to mainstream investing advice, there’s a consistent recommendation you find regardless of which country you’re in, how old you are or whether you’re looking at an ISA, a SIPP or just a general investment account.

Invest in index funds.

YouTubers, TikTokers and Twitterers (Tweeters?), are constantly espousing the benefits of ‘buying the entire stock market’ through index funds, using examples like Warren Buffet to suggest that it’s the only way to invest.

This advice gives the perception that index funds are some infallible, unbiased, pure way to access the market, allowing investors a perfect way to avoid fees and the risk of poor management.

But there’s a serious flaw in this logic. Index funds are fake.  

Or more specifically, the indexes that they’re based on are fake. Not fake as in they don’t exist, but fake as in, they are entirely made up by for-profit companies. The government or the regulator has no input on indexes. Like everything in the markets, they’re a financial product which has been created to generate profits for the company that creates it.

Confused? Mind a little blown? Let’s explain.

What is an index?

Ok so the concept of an index is simple on the surface, but gets more complicated the more you look into it. In the most straightforward terms, an index is a basket of securities that has been designed to represent a certain sector, stock market, industry, asset class or geographic region.  

Straightforward so far. But who decides which stocks are to be included in an index that is designed to represent these categories? Well, that’s down to the company who creates the index.

That’s right, indexes are simply an information product that has been created by a company. The best known index globally is the S&P 500. Ask anyone on the street what the S&P 500 represents and if they’ve heard of it, they’ll probably tell you that it’s the 500 biggest companies in the US. 

It’s considered to represent the US market as a whole, and when we hear that the ‘US market’ was up X amount - that almost always refers to the S&P 500.

But did you know that the companies included in the S&P 500 are decided by a committee? 

That’s right. The S&P 500 isn’t simply the biggest companies in the US. It’s an index which is owned and operated by S&P Global and CME Group, and at the end of the day it’s a discretionary index that looks at a range of different factors, not just the size of the company.

The list of indexes is almost never ending. There are other major ones like the FTSE 100, the Nasdaq 100, the Dow Jones or the Russell 2000, and less well known ones like the EGE 30 (Egypt), the Zimbabwe Mining Index or the CSE 30 (Bangladesh).

Outside of specific stock markets, there are indexes for bonds, for commodities, for individual sectors like energy or telecommunications, and multi-asset indexes based on risk levels or targeted retirement dates.

It’s practically endless, and they have all been created by financial institutions.

That’s not to say they’re not useful. It’s not to say that having a benchmark isn’t valuable. But it’s important for even the most ardent Warren Buffet fans to realise that indexes are not a pre-ordained list of companies handed down by God (or Jerome Powell).

How index funds track the index

So by extension then, index funds are simply funds that track these indexes, right? Well yes, but again it’s not quite that straightforward. If you’re buying an index fund that tracks a single index, say a FTSE 100 tracker, then you do have a good idea on what you’re going to get.

But not all index funds are created equal.

Some index funds really do purchase all of the holdings in the underlying index. Like a FTSE 100 index that actually holds all 100 of the companies on that list. This is called full replication. But many don’t. 

Some use a method known as sampling, aiming to match the performance of the index while only investing in a sample of the assets within it.

Others don’t even invest in the asset class at all! Instead, they use complicated derivatives known as swaps to track the performance of the assets. It is called synthetic replication if you look closely into the factsheets of those funds. 

None of these are right or wrong, and you don’t need to understand the ins and outs of how each of the methods works. The important takeaway is that not all index funds are created equal, and that just because they have the label of ‘index fund’ doesn’t mean they’re really any different to any other ETF or investment fund.

Not only that, but the different methods of replicating the index produce different results. The gap between the returns of the index and the returns of the ETF or index fund are known as the ‘tracking error,’ and it’s an important metric when choosing an investment. 

Are multi-asset index funds really passive?

When we get into multi-asset index funds - that is funds that hold more than one type of asset e.g. stocks and bonds instead of just stocks - things get even more interesting. And while the key objectives or index funds in this category are still the same - low fees and market average returns, they start to look a lot more like actively managed funds.

How does this work? Well, say that you have an index fund which is targeting a 50/50 split between stocks and bonds. Who decides which markets to buy for the stocks component? What component should the fund invest in, for example, UK equities and US equities?? Should there be some Japanese and Australian markets in there too?

What about bonds? Which percentages should be allocated to government bonds as opposed to corporate bonds?

All of these underlying investments could be made into individual specific index funds, but the asset allocation is still actively managed. 

Again, this isn’t a problem, as long as you understand what it is you’re investing in and how the portfolio is managed.

Index as a benchmark

The term index automatically makes most people think of index funds. As we’ve talked about so far, this is one of the biggest use cases for index products. But at its core, an index really is just a benchmark.

An index fund is just an investment product that is designed to track that benchmark. 

That’s pretty simple if you’re investing in an S&P 500 or a FTSE 100 index fund, because the benchmark is obvious. But another way indexes can be useful for investors is as a bellwether of how a portfolio is performing.

For example, say you’re investing in that 50/50 stocks and bonds portfolio. It would be pretty unfair to use the S&P 500 as a benchmark for that, because the fund will almost surely underperform over the long term because it only has half as much in the stock market as the index.

By the same token, a ‘cautious’ benchmark of 30% shares isn’t a good comparison either. 

For investors, choosing the right benchmark is really important to understand if your portfolio is performing as it should. Not just in terms of returns, but in terms of volatility/risk as well. As always, the best way to pick the right benchmark is by having a really clear idea of what you’re trying to achieve.

This comes back to a wide range of factors, like how much risk you want to take, how much volatility you’re prepared to accept, whether you want a dividend or a growth focus or whether you have any specific investment requirements such as investing in an ethical or ‘green’ way.

Because there are so many different indexes out there, you’ll almost certainly be able to find a benchmark index that matches your investment objectives. Our recommended set of benchmarks, and widely considered the gold standard for UK private banks and wealth managers, are from Asset Risk Consultants (ARC).

They offer impartial and unbiased comparisons between different investments, and offer benchmarks across just about every asset type, sector and class that there is.

The takeaway

We’ve gone into the weeds a bit here, but it’s important to understand what you’re buying when you’re investing into index funds. It’s not to say you shouldn’t do it, and in many cases it actually makes a lot of sense to utilise index ETFs or funds. Rosecut uses a lot of index trackers in our portfolio for example, after an in-depth research and selection process. But by the same token, just because a fund is billing itself as an index fund, doesn’t necessarily mean it has all the characteristics you’d expect it to have.

As always, it comes down to doing your research on what you’re investing in, and making sure you understand exactly what it is and how it works. Or of course, you can speak to Rosecut, and let us worry about benchmarks and investment options for you.