What is an index fund, and what does passive investing mean?
An index fund holds the constituents of a market index in the same proportions, aiming to match the index's return rather than beat it. That is what "passive" means: no one is choosing what to buy.
What an index is. A defined list of securities with rules for membership and weighting — the FTSE 100, the S&P 500, the MSCI World. Most are market-capitalisation weighted, so bigger companies make up a larger share.
How the fund tracks it. Either by full replication — holding everything in the correct proportion — or by sampling a representative subset where the index is very large. Some use derivatives, which introduces counterparty risk.
Tracking error measures how closely the fund follows the index, and is the main technical quality measure.
Why passive investing became dominant:
Cost. No research team, no analysts, minimal trading. Ongoing charges are typically a small fraction of an active fund's. Over decades, the difference compounds into a very large amount — this is the core argument, and it is arithmetic rather than opinion.
The evidence on active management. The consistent finding across long-running studies is that the majority of active funds underperform their benchmark after costs, and that the proportion doing so increases with the time horizon. Some managers do outperform; identifying them in advance is the difficulty, and past performance predicts future performance poorly.
The underlying logic, sometimes called the arithmetic of active management: all investors collectively hold the market, so before costs the average actively managed pound earns the market return. After costs, it must earn less. Active management is a zero-sum game before fees and negative-sum after.
The genuine criticisms:
You buy the whole index, including overvalued companies — by construction you buy more of whatever has risen.
Concentration. Cap-weighted indices have become dominated by a small number of very large companies, so "diversified" is less true than it sounds.
Price discovery and governance concerns if passive ownership grows very large.
No downside protection — you track the index down as well as up.
General information, not investment advice.