What index funds are, and how to choose the right one

Low-cost investing has become one of the most well-supported ideas in modern finance, and index funds are the vehicle that made it mainstream. Although as a term, index investing is used almost as often as passive investing, the two are not the same thing. 

The evidence for passive management is robust. The SPIVA Scorecard, published by S&P Dow Jones Indices, shows that over a 15-year period ending December 2024, there was not a single US equity category in which a majority of active managers outperformed their benchmark after fees. 

Academic research, including the landmark 2010 paper by Eugene Fama and Kenneth French, reaches the same conclusion: aggregate active fund portfolios underperform after costs, and most outperformance is better explained by luck than skill. That case is compelling—but it is a case for low-cost, passive management, not for index funds as a category.

Most index funds are passively managed. That is why the two ideas are so often conflated. But some index funds are not passive, and some passive strategies do not track a published index at all. This guide explains how index funds work, where the distinction matters, what the evidence actually says, and how to choose a fund that delivers what you are looking for.

What is an index fund?

An index is a list of securities—shares, bonds, or other assets—grouped and weighted according to a defined methodology. The S&P 500 tracks the 500 largest publicly listed companies in the United States by market capitalisation. The MSCI World tracks large- and mid-cap equities across 23 developed markets. The Straits Times Index (STI) tracks the 30 largest companies listed on the Singapore Exchange (SGX).

An index fund is an investment vehicle designed to replicate the performance of a chosen index by holding its constituent securities in proportion to their index weights, delivering, net of a modest fee, the return of the market it tracks. 

Index funds are available in two main structures. The first is a unit trust (also called a mutual fund), priced once daily after markets close and transacted directly with the fund house. The second is an exchange-traded fund (ETF), typically (but not exclusively) listed on a stock exchange and tradeable throughout the day at market prices. The underlying investment logic is the same; the main difference is how and when you transact.

Index fund versus passive investing: why the distinction matters

Passive investing describes a philosophy—low turnover, low cost, no attempt to beat the market through security selection or market timing. Index tracking is the most common way to implement that philosophy, but it is not the only way, and not all index funds qualify.

Some index funds are not passively managed. Leveraged and inverse ETFs track an index but require constant daily rebalancing using derivatives—they are active in their mechanics and do not behave like a buy-and-hold vehicle. Thematic index funds track custom-constructed indexes, but the index itself embeds active judgements about which companies belong in a category. The fund is passive relative to its own index; the index construction is an active decision.

Conversely, some passive strategies do not track a published index at all. Dimensional Fund Advisors, for example, targets factor exposures—value, profitability, size—systematically and with low turnover, but retains discretion over execution and does not follow a specific benchmark. By philosophy and cost structure, it is passive; by structure, it is not an index fund.

For most investors building a core portfolio, this distinction is practical rather than academic. It means that when you see the words "index fund" on a product label, the relevant follow-up questions are: what does the index actually measure, who constructed it, and does the fund's cost structure and turnover reflect genuine passive management?

How does an index fund work?

Index funds pool investor capital to purchase the constituent securities of a chosen index. The fund manager exercises no discretion over security selection—the sole objective is to track the index as closely as possible. 

Most major indexes use a free-float, market-capitalisation-weighted methodology. Each security is weighted according to the total market value of its publicly available shares. Under this methodology, a company's weight in the index—and therefore in the fund—rises and falls with its market capitalisation relative to the total capitalisation of all index constituents

The fund manager rebalances the portfolio periodically, or when the index itself changes, to maintain alignment with the benchmark. Because this process is largely mechanical, it requires fewer analysts and less active decision-making than traditional fund management. This is why broad market index funds can typically charge significantly lower fees than actively managed alternatives.

It is worth noting that market-cap weighting has a structural consequence: flows into a cap-weighted index fund mechanically increase the weight of whatever is already most expensive. This is not a flaw unique to index funds—it is a feature of the methodology. But it is one reason some investors use equal-weighted or fundamentally weighted index funds as a complement, even though those products sit closer to the active end of the spectrum.

Does evidence support low-cost, passive investing?

The data supporting passive management is extensive and consistent, with the important caveat that it supports passively managed, low-cost funds, not index funds as a category.

The SPIVA Scorecard compares actively managed funds against their benchmark indexes across time horizons and markets. Over a 15-year period ending December 2024, no US equity category had a majority of active managers outperforming—zero out of 22 categories. Over a 20-year period ending the same date, 94.1% of all domestic US funds underperformed the S&P 1500 Composite Index. Asia-Pacific markets tell a broadly similar story, though active management fares somewhat better in less efficient markets where information asymmetries may still exist.

Academic research reinforces these findings. Fama and French (2010) found that the aggregate portfolio of actively managed US equity mutual funds underperformed by 0.8 percentage points per year between 1984 and 2006. Even after adding back all expense ratios, aggregate alpha was effectively zero. The evidence from this academic research does not suggest that no active manager has skill—it suggests that fees consume most of the value that skill generates, and that identifying the skilled managers in advance is extremely difficult.

Active management does play a role in markets. It contributes to price discovery, particularly in less efficient segments such as small-cap equities. The 2024 SPIVA data showed that small-cap active managers had their best year in over two decades. But for most long-term investors building a core portfolio, the aggregate evidence favours low-cost passive exposure over active management. 

What are the key benefits of index funds?

When an index fund is also genuinely passively managed, it offers several structural advantages.

• Lower costs. Broad market index funds do not employ large teams of analysts. Operating costs are lower and pass through to investors as lower fees—sometimes as little as 0.03% to 0.10% per year for major market index funds, compared to 1% or more for many actively managed alternatives.
• Broad diversification. A single index fund tracking the MSCI World may hold exposure to over 1,400 companies across 23 countries, reducing the impact of any single company or sector on portfolio performance.
• Transparency. Index funds typically disclose their holdings and methodology openly. You know what you own and why, which is not always the case with actively managed funds.
• Reduced manager risk. With active funds, performance depends on the skill and decisions of the portfolio manager. A broad market index fund removes this variable: the fund tracks a pre-determined exposure, and no individual's judgement causes the fund to stray significantly from its benchmark.
• Tax efficiency (in relevant markets). Index funds trade less frequently than active funds, typically generating lower levels of taxable events in markets where capital gains taxes apply.

These advantages apply most clearly to broad market, cap-weighted index funds from large, low-cost providers. They apply less clearly to leveraged ETFs, thematic funds, or index funds with high turnover or opaque index construction.

What index funds do not do

Index funds do not protect you from market downturns. If the market falls 30%, a fund tracking that market may fall by approximately the same amount. There is no defensive repositioning, no move to cash, and no attempt to reduce risk ahead of a correction. Index investing accepts market risk in full.

A market-cap-weighted index is also typically overly exposed to large and mega caps. With technology stocks dominating global indexes in the early 2020s, index funds that track major markets may expose investors to the sector’s risk-return profile . This is a feature of the methodology, not a flaw, but it is something to understand before investing.

Finally, not all indexes offer broad diversification. A thematic or single-country index fund may hold a narrow basket of securities with high correlation. The word "index" does not automatically mean broad or diversified.

What types of index funds are there?

Index funds may track virtually any market, asset class, or factor. The most common categories include:

• Broad equity indexes: S&P 500 (US large-cap equities), MSCI World (developed market equities), MSCI ACWI (developed and emerging market equities), MSCI Emerging Markets.
• Regional and country indexes: Straits Times Index (Singapore), Hang Seng Index (Hong Kong), FTSE 100 (UK), Nikkei 225 (Japan).
• Bond indexes: Track government bonds, corporate bonds, or a blend across credit qualities and maturities.
• Factor indexes (sometimes called smart beta): Weighting securities by value, quality, low volatility, or momentum rather than market cap. These sit between pure passive and active management, and should be evaluated accordingly.
• Thematic indexes: Tracking sectors or themes such as technology, clean energy, or healthcare. Index construction here involves active judgements about category membership.

For most investors, the starting point is a broad equity index and a broad bond index from a large, low-cost provider. Factor and thematic index funds are typically better suited to investors who already have a core portfolio and want to express a specific view.

How to choose the right index fund

With hundreds of index funds available, the choice can feel overwhelming. Here is a structured way to think about it.

1. Start with the index. The index a fund tracks determines what you own. Before looking at the fund itself, confirm the index covers the right geography, asset class, and level of diversification for your goals — and consider who constructed it and how.
2. Assess whether it is genuinely passively managed. Check the fund's turnover, use of derivatives, and rebalancing frequency. A leveraged ETF or actively constructed thematic fund may sit under the "index fund" label but behave very differently from a broad market passive vehicle.
3. Check the total expense ratio (TER). This is the annual cost of holding the fund, expressed as a percentage of assets. For broad equity index funds, a TER below 0.20% is generally considered competitive. 
4. Look at tracking difference, not just tracking error. Tracking error measures volatility of returns relative to the index. Tracking difference measures whether the fund consistently out- or underperforms the index over time. A negative tracking difference—where the fund slightly outperforms the index net of fees—is possible when securities lending income offsets costs, and is the more useful metric.
5. Consider fund size and liquidity. Larger funds tend to have narrower bid-ask spreads (for ETFs) and are less likely to be closed. A fund with assets under management (AUM) above US$500 million is generally considered well-established for major benchmarks.
6. Understand dividend treatment. Accumulating funds reinvest dividends automatically, compounding returns over time. Distributing funds pay dividends out to investors. Which is preferable depends on your income needs and the tax treatment of dividends in your jurisdiction.
7. Think about currency. Investing in a USD-denominated index fund when your base currency is the Singapore dollar introduces foreign exchange risk. Some funds offer currency-hedged share classes that reduce this exposure, but hedging by definition comes with a cost. 

What this means for your portfolio

Low-cost, broadly diversified index funds typically make most sense as the core of a long-term portfolio—not as a trading vehicle, and not as a substitute for thinking carefully about asset allocation.

The evidence supports passive management as an approach, especially for investors with information asymmetry, limited time and knowledge of markets. It supports index funds as a vehicle to the extent that most index funds are the most accessible and cost-effective way to implement that approach. The two things travel together for most investors most of the time. But when they diverge—as they do with leveraged ETFs, high-turnover thematic funds, or custom-constructed indexes—the evidence for passive management does not automatically extend to the product.

A straightforward starting point for many long-term investors is a globally diversified equity index fund paired with a broad bond index fund, in proportions that reflect their risk tolerance and investment horizon. Held consistently and rebalanced periodically, this combination has historically delivered solid long-term returns at a fraction of the cost of active management, though past performance is not necessarily a guide to future performance or returns.

On the Endowus platform, you may access institutional-share-class index funds from leading global providers at significantly lower fees than retail equivalents available at most banks. Our Flagship Portfolios use index funds, selected, diligenced and monitored by our investment team, as core building blocks. You may also invest your Central Provident Fund (CPF) Ordinary Account (OA) savings and Supplementary Retirement Scheme (SRS) funds, in eligible index funds. 

Frequently asked questions about index funds

Are index funds safe?

All investments carry risk, and index funds are no exception. A global equity index fund may lose significant value during market downturns. By holding a diversified basket of securities, broad market index funds reduce the risk specific to any single company or sector (“idiosyncratic risk”). Over long time horizons, broadly diversified index funds have historically recovered from market falls. 

Are all index funds passively managed?

No. Most broad market index funds are passively managed, but leveraged ETFs, inverse ETFs, and some thematic funds track an index while requiring active daily management or embedding active judgements in the index construction. When evaluating a fund, check its turnover, use of derivatives, and how its underlying index was constructed.

What is the difference between an index fund and an ETF?

Both may track an index, but they differ in structure. A traditional index fund (unit trust) is priced once daily and transacted directly with the fund house. An ETF is listed on a stock exchange and may be traded throughout the day at market prices. For long-term investors, this distinction matters less than the underlying index and the fund's total cost.

How much does it cost to invest in an index fund?

Broad market ETFs from large providers may charge as little as 0.03% to 0.10% per year. Some retail index funds charge 0.5% or more. On Endowus Fund Smart, a few index funds such as the iShares Developed World Index Fund (IE) are offered at institutional pricing—this means you can access them at lower fees compared to the same fund offered at retail pricing at banks and other fund platforms.

Can I use CPF or SRS savings to invest in index funds?

Yes. Endowus allows you to invest your CPF OA and SRS funds in eligible index funds. This is one way to put otherwise underutilised savings to potentially work for long-term growth, within CPF and SRS guidelines.

Is it better to invest in one index fund or several?

One well-chosen, globally diversified index fund  may provide sufficient equity diversification for many investors. Adding a broad bond index fund introduces a second asset class that may reduce portfolio volatility during equity drawdowns. Beyond that, the benefit of adding further index funds depends on whether they genuinely add diversification or simply add cost and complexity.