Understanding Index Funds: Why All Index Funds Aren’t the Same

ALL INDEX FUNDS ARE NOT CREATED EQUALLY

The popularity of index funds has exploded over the last few decades, changing the way individuals invest their assets. Praised for their simplicity, low fees, and consistent performance relative to actively managed funds, index funds have attracted trillions of dollars in assets. Index funds tracking the performance of the S&P 500 have become the most popular, as the world’s largest custodians all have their own versions of an S&P 500 index fund. Schwab, Vanguard, Blackrock, and Fidelity are among the asset managers and custodians with billions of investor assets in a single index fund.

However, what many investors do not realize is that all index funds are not the same. A common misconception is that an index fund must invest in the S&P 500 (A market capitalization index tracking five hundred of the largest publicly traded companies in the U.S.). In fact, there are hundreds of indices that can be tracked by a fund. Examples of strategies an index fund may track include sectors, industries, regions, countries, commodities, and bonds.

Just because two funds track an “index” does not mean they behave the same way or deliver the same after-tax returns. Differences in index construction, fees, fund structure, and tax efficiency can create a meaningful divergence in outcomes even when two funds appear nearly identical on the surface. You may be surprised to learn the level of due diligence involved in selecting the proper index fund.

This article explores why understanding index funds matters and suggests strategies for choosing the right one for your needs.

Why Index Funds Are So Popular

Index funds aim to replicate the performance of a market benchmark like the S&P 500 or the total U.S. stock market by holding the same securities in roughly the same proportions. Their appeal is grounded in low cost, diversification, simplicity, and transparency.

Performance is a common reason cited for choosing an index fund. While very few actively managed large cap funds have been able to outperform the S&P 500 (According to one study, only 12% did so over the 15 years from 2008 through 2023.)[i], the evidence is not as convincing for index funds tracking other market segments and asset classes. Investors should also keep in mind that past performance is not necessarily predictive of future results.

Please do not misinterpret this disclosure as an attack on index funds. In fact, they are an especially useful tool in helping investors build a diversified portfolio and accumulate wealth.

What Should You Know About Index Funds?

Index Construction: Cap-Weighted vs. Equal-Weighted

The structure of the index a fund tracks determines how your money is allocated. A cap-weighted fund is the most common index structure. Market capitalization of a stock is calculated by multiplying the number of outstanding shares by the price of the stock. Therefore, in a cap-weighted index, the largest stocks have an outsized influence on performance. Companies like Nvidia, Apple, and Microsoft will impact the S&P 500 index returns, more than Clorox, Best Buy or Domino’s.

Equal-weighted funds give each company the same influence on returns, resulting in enhanced diversification and greater exposure to smaller stocks. The structure’s drawback is higher turnover and potentially higher taxes.

When the top names are thriving, a cap-weighted index can be attractive. U.S. stocks have experienced a multi-year cycle where the largest companies have outperformed smaller peers, and as a result the cap weighted S&P index has outperformed over the last 3-, 5-, and 10-year periods.[ii] An analysis of many of the prominent sector funds, will tell a similar story. Cap weighted sector index funds have outperformed their equal weighted peers. Markets have experienced a multi-year cycle of mega cap stocks outperforming smaller companies; therefore, the trend is not limited to the broad indices like the S&P 500 or the Nasdaq.

There is a downside of mega cap strength: As of June 30, 2025, the S&P 500 had a record level of concentration. Consequently, the top ten names make up nearly 40% of the index. [iii] Less diversification typically means more volatility and risk. The equal-weighted index did outperform in 2022 when the S&P 500 lost 18% and the equal-weighted index fell less than 12%.[iv]. Concentration among the largest names in cap-weighted sector indices is more extreme than the broad, more recognizable indices.

If there is one lesson for investors to take from index construction, it is to understand what you own. An index may not be as diversified as expected. You may be taking a bet on a handful of companies, while owning a small fraction of another hundred names with a negligible impact on performance. It is also important to avoid choosing an index based exclusively on past performance. Review the holdings of the index and confirm the percentage of assets dedicated to the largest positions within the fund, ensuring the fund is appropriate for your risk tolerance.

Index Funds with High Expenses? It Happens!

Index funds are generally inexpensive, but not equally so. Many employer-sponsored retirement plans still offer index funds with expense ratios exceeding 0.50%. Investors should also be aware of obscure indices, as the fund provider may create them to capture assets and generate revenue. If there is less competition tracking the index, the fund provider is more likely to charge a premium.

Always compare expense ratios. Even slight differences can compound over time. Expense ratios are typically easy to find on the custodian or plan provider’s website. You may see the term operating expense or net expense ratio; both will tell you what you are paying to the fund company.

An S&P 500 index fund may only charge 3 or 4 basis points (0.03% or 0.04%). A diversified international index fund is typically more expensive but many charge less than 15 basis points. The cost of funds tracking a sector or a subcategory of a broader index (large value or large growth) can vary widely and requires additional due diligence.

ETFs and Index Funds: Not Quite the Same

Exchange-Traded Funds (ETFs) and mutual funds can track the same index but differ in how they trade and their tax efficiency. Mutual funds will trade at the end of the day, and you will not know the price you receive at the time of the order. ETFs are traded continuously during market hours, resulting in execution prices that usually vary by only a minimal amount from the most recent quoted price.

A key distinction is in how each vehicle redeems shares. A mutual fund must raise cash by selling shares of the underlying stock of the fund to meet redemptions. If the shares the mutual fund sold have appreciated, the fund has capital gains. These gains must be distributed to shareholders and are fully taxable. Most index mutual funds distribute capital gains in December. If you purchase an index mutual fund in November, you may receive a capital gain distribution the following month even if you experience a loss in the fund. Your index fund may have owned Microsoft or Apple for twenty years. The fund must distribute those capital gains proportionately to current shareholders, regardless of when the shareholder purchased the fund.

Index mutual funds are more tax-efficient than actively managed mutual funds because the index fund is not regularly buying and selling the underlying companies. However, shareholder redemptions and the occasional rebalancing to reflect changes in the index, can result in capital gain distributions.

ETFs are structured in a way that is more favorable for tax purposes, and they are not required to distribute capital gains to shareholders. While ETFs are more tax-efficient than mutual funds, they can distribute taxable income in the form of dividends or interest.

Tax Efficiency: One of the Most Overlooked Differences

Some index funds have high turnover or distribute capital gains, especially in categories like small-cap or ESG. Bond index funds are particularly tax-inefficient due to ordinary income treatment of interest.

The quickest way for an investor to assess the tax efficiency of their index fund is to review the tax cost ratio – the percentage of the return lost to taxes. When comparing two investments with equal returns, the investment with the lower tax cost ratio is, usually more favorable for the investor.

The tax cost ratio’s impact on the index fund is similar to an operating expense. The range can vary from 0.50% for an S&P 500 ETF to over 2% for a high yield bond index. Actively managed mutual funds have experienced years with large capital gains, sending their tax cost ratios over 5%, so this is a measure you will want to evaluate prior to investing in an index fund in a non-retirement account.

Keep in mind that tax cost ratio is irrelevant in a tax advantaged account such as an IRA or 401(k), where you only pay tax when withdrawing funds. On the other hand, tax efficiency is critical when assessing investments in a non-retirement account.

Conclusion: Look Beneath the Surface

The increasing popularity of index funds is warranted; however, variations in their structure, fee arrangements, and tax implications require careful consideration prior to investing.

Ask yourself these questions: