ETFs and Index Funds Explained: S&P 500, Nasdaq-100 and Why Most Traders Trail the Index

An index fund is a fund that holds all the stocks in an index, such as the S&P 500, in the same proportions as the index, for a very small annual fee. An ETF (exchange-traded fund) is a fund whose units trade on a stock exchange like a single share, and many of the biggest ETFs are index funds. For most people a low-cost index ETF is the benchmark to beat, and most active traders and fund managers fall behind it after costs over long periods.

What an index fund does

An index is a rulebook for a basket of stocks. An index fund follows that rulebook and does not try to pick winners.

• S&P 500: about 500 large US companies chosen by a committee using rules on size, profitability and trading volume. It is market-cap weighted: a company worth $3 trillion has 30 times the weight of one worth $100 billion.
• Nasdaq-100: the 100 largest non-financial companies listed on Nasdaq, including some foreign companies. It leans heavily towards technology.

Because both are market-cap weighted, a few giant companies now make up a large share of each index. Owning the index is diversified across hundreds of companies, but its moves are driven mostly by its biggest names.

ETFs and mutual funds

	ETF	Traditional mutual fund
How you buy	Through a broker, during market hours, like a stock	From the fund company, once a day at the closing value
Price	Moves all day, stays close to the value of its holdings	One price per day (the net asset value)
Minimum	One share, or less with fractional shares	Often a minimum investment
Typical cost	Low annual fee for index ETFs, plus the spread	Varies widely

The annual fee is the expense ratio, taken from the fund's assets a little each day. You never see a bill, which is why people ignore it.

Why fees matter so much

Some of the largest S&P 500 ETFs charge only a few hundredths of a percent a year. Fees change, so check the fund's current fact sheet.

How to choose an index ETF

1. The index: S&P 500 for broad large US companies, Nasdaq-100 for a technology-heavy slice, a total-market fund for large and small companies together.
2. Expense ratio: lower is better when two funds track the same index.
3. Size and trading volume: large, busy ETFs have tight spreads.
4. Where the fund is based: US-listed ETFs are common, but some non-US investors use funds based in Ireland or elsewhere (often labelled UCITS) because dividend taxes inside the fund and US estate tax can be treated differently. What your broker offers, and what is better for you, depends on where you live; check with a tax adviser.
5. Accumulating or distributing: distributing funds pay dividends to you; accumulating funds reinvest them inside the fund.

Why most active traders fail to beat the index

This is not an insult to traders. It follows from a few hard facts:

1. Arithmetic. All investors together own the whole market. Before costs, the average investor must earn the market return. Index investors get that return at almost no cost, so active investors as a group must also earn it before costs and less after their higher costs. The economist William Sharpe set out this "arithmetic of active management" in 1991.
2. Costs and taxes. Spreads, commissions, slippage and taxes on short-term gains are paid every time you trade (see the turnover example in trading vs investing).
3. A few stocks do most of the work. Research by Hendrik Bessembinder (2018) found that most individual US stocks did worse than one-month Treasury bills over their lifetimes, and that a small minority of stocks produced the stock market's overall gains. A concentrated portfolio can easily miss them; an index cannot.
4. Behaviour. Many investors buy after prices have risen and sell after they have fallen. Studies of brokerage accounts, such as Barber and Odean (2000), found that the households that traded most earned less than those that traded least.

The evidence for professionals points the same way. S&P Dow Jones Indices' SPIVA reports have for many years found that most actively managed US large-company funds trailed the S&P 500 over 10- and 15-year periods. Some managers and traders do beat the index, but it is hard to identify them in advance.

DanioX does exactly this. The stocks backtest shows each tested strategy next to the S&P 500 over the same period, after costs, and the methodology page explains how. Many rules that look clever on their own fail that comparison.

Other kinds of ETF

• Sector ETFs hold one industry, such as technology or energy (see sector rotation and correlation).
• Equal-weight ETFs give each company the same weight, which reduces dependence on the giants but increases trading inside the fund.
• Dividend ETFs pick companies by dividend yield or growth.
• Leveraged and inverse ETFs aim for 2x or 3x the daily move, or the opposite of it.

Next, learn how companies hand cash back to their owners: dividends and buybacks.