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Research Library · Study 14

Low-Cost Index Investing: Why Most Funds Trail the Market

  • 11 short cards
  • About 6 min to read
  • 5 quiz levels · 30 questions
  • Beginner

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Overview

Index investing means buying a fund that simply owns a whole market, such as the 100 largest UK companies or thousands of companies worldwide, instead of paying a manager to pick winners. When it comes to index funds vs active funds, the case rests on a short piece of arithmetic and decades of scorecards.

Timeframe
Years to decades
Markets
Index funds and ETFs: shares, bonds or both
Difficulty
Beginner

Sharpe’s arithmetic

In 1991 William Sharpe pointed out something that has to be true by definition1. Split every investor in a market into two groups: passive investors, who simply hold the whole market, and active investors, who try to beat it.

The passive group earns the market return, before costs. Together, both groups *are* the market. So the active group, on average, must also earn the market return before costs. Some active investors beat it, but only because others lag it by the same amount.

Now add costs. Active funds charge more for research and trade more often. So after costs, the average active pound must earn less than the average passive pound. That isn’t a forecast. It’s arithmetic.

Sharpe’s arithmetic with made-up numbers (market return 7% a year)

  • Passive, before costs7.0%
  • Passive, after a 0.1% charge6.9%
  • Average active, before costs7.0%
  • Average active, after a 0.9% charge6.1%

Before costs, both groups must average the market return, because together they are the market. Costs are the only difference left.

What the scorecards show

S&P Dow Jones Indices checks this twice a year in its SPIVA scorecards, which compare active funds with the index each one is measured against, called its benchmark.

In the Europe scorecard to June 2026, 94% of the equity funds covered lagged their benchmark over 10 years2. In the US, 89% of large-company funds lagged the S&P 500 over the five years to the end of 20253.

Across most categories, the longer the period, the more funds fall behind. Some active funds do beat the market, but the hard part is knowing which ones in advance.

Share of active funds that lagged their benchmark (SPIVA)

  • Europe equity funds, 10 years to June 202694%
  • US large-company funds, 5 years to end of 202589%

Source: S&P Dow Jones Indices SPIVA scorecards, as quoted in this lesson. Some funds did beat the index; the hard part is knowing which in advance.

Why small fees matter so much

A fund’s yearly charge comes out of your money every year, and it also takes away the growth that money would have earned4.

Say you invest £10,000 for 30 years and the investments grow 6% a year before fees. With a 0.1% yearly fee you end up with about £55,800. With a 1% fee, about £43,200. That 0.9% gap costs you around £12,600. The figures are an illustration, not a forecast.

£10,000 growing for 30 years: a 0.1% fee against a 1% fee

£0£20,000£40,000£60,000Start5 yrs10 yrs15 yrs20 yrs25 yrs30 yrs
  • 0.1% yearly fee (grows 5.9% a year)
  • 1% yearly fee (grows 5% a year)

Both start the same. After 30 years the gap is about £12,600. Assumes 6% growth a year before fees: an illustration, not a forecast.

The catch

An index fund gives you the market’s return, including every fall. It won’t protect you in a crash, and a fund tracking one country or one industry can fall much further than a global one.

Some indexes are dominated by a handful of very large companies, so “owning the market” can mean more of a few names than you expect. Check what an index holds before you choose it.

Not every index fund is equally spread out

Global share index

  • Thousands of companies
  • Many countries and industries
  • Still falls in a crash

One country’s index

  • Fewer companies
  • Can lean heavily on a few big names
  • Can fall further than a global fund

One industry

  • All the companies face the same risks
  • The least spread out
  • Can fall very hard

Index investing rules

Entry

  • Choose a broad, low-cost index fund or ETF, such as a global share index. Many charge well under 0.3% a year.
  • Hold it in a tax-free or pension account if your country offers one, such as an ISA or SIPP in the UK.
  • Invest regularly, for example every month.

Exit

  • Sell only when you need the money or your plans change, not because of the news.
  • As the date you need the money gets closer, move part of it into bonds or cash.

Risk

  • Keep emergency savings in cash first.
  • Spread across countries and industries. A single-country fund is less diversified than it sounds.
  • Check the total cost: the fund’s yearly charge plus the platform fee.

Worked example: two funds, the same market

  1. You have £10,000 to invest in UK shares. Fund A is an index tracker charging 0.1% a year. Fund B is an active fund charging 0.9%.
  2. In the first year, Fund A costs you £10 and Fund B costs you £90.
  3. For Fund B to come out ahead, its manager must beat the market by more than 0.8% a year, after trading costs, every year. Most funds in the SPIVA scorecards don’t manage that over 10 years.

Pros and cons of index investing

Strengths

  • Very low cost, so more of the return stays with you.
  • Simple: no need to pick fund managers or companies.
  • Spreads your money across hundreds or thousands of companies.

Weaknesses

  • You get the market’s falls in full, with no attempt to avoid them.
  • Some indexes lean heavily on a few very large companies.
  • You’ll never beat the market. You aim to match it, minus a small fee.

Key terms

Index
A list of companies used to measure a market, such as the FTSE 100 or the S&P 500.
Index fund (tracker)
A fund that holds the companies in an index, so it rises and falls with that market.
Active fund
A fund whose manager picks investments, trying to beat the market.
Benchmark
The index a fund is measured against.
Ongoing charge
A fund’s yearly fee, taken from its value. In the US it’s called the expense ratio.
SPIVA
S&P Dow Jones Indices’ regular scorecards comparing active funds with their benchmarks.

Lesson complete

You have reached the end of the lesson. Now test what you learned with the five-level quiz.

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Quiz zone

Test yourself: Low-cost index investing quiz

Five levels, from the basics to expert judgment. Clear each level to unlock the next.

  1. Level 1: Foundations. Recognise the strategy and its vocabulary.
  2. Level 2: Mechanics. Know how the signals and rules work, and why.
  3. Level 3: Application. Apply the rules to realistic chart situations.
  4. Level 4: Numbers & risk. Size, measure and manage the trade with real calculations.
  5. Level 5: Mastery. Judge edge cases, failure modes and market conditions.

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The questions only. Answers and explanations appear when you take the quiz above.

Level 1: Know the basics

  1. What does an index fund do?

    • Guarantees a return
    • Picks the best shares to beat the market
    • Holds the companies in an index, so it moves with that market
    • Only holds cash

  2. What is a fund’s benchmark?

    • Its best year ever
    • The fund manager’s name
    • The index it’s measured against
    • Its yearly fee

  3. True or false: an index fund can still fall sharply in a market crash.

    True or false?

  4. What do the SPIVA scorecards compare?

    • One country’s tax with another’s
    • Gold with shares
    • Active funds with the index each one is measured against
    • Index funds with savings accounts

Level 2: Understand how it works

  1. Before costs, what must the average active investor earn?

    • The market return
    • More than the market
    • Less than the market
    • Nothing at all

  2. Why must the average active pound trail the average passive pound after costs?

    • Passive funds get special prices
    • Active managers aren’t clever
    • The government taxes active funds more
    • Active funds have higher costs, taken from the same market return

  3. True or false: Sharpe’s argument means no active fund ever beats the market.

    True or false?

  4. In SPIVA scorecards, what usually happens to the share of funds trailing their benchmark as the period gets longer?

    • It tends to fall
    • It tends to rise
    • It drops to zero
    • It stays exactly the same

  5. Why does a yearly fee cost more than it first looks?

    • It doubles every year
    • It’s charged twice
    • It takes your money every year, and also the growth that money would have earned
    • It doesn’t: fees are tiny

Level 3: Use it

  1. You want broad, low-cost exposure to shares worldwide for 20 years. Which fits best?

    • Cash only
    • One technology fund
    • A fund that changed manager last year
    • A global share index fund with a low yearly charge

  2. An index fund tracks one country’s market. What should you check?

    • Whether it’s popular online
    • The colour of the logo
    • How much of it sits in a few companies or industries
    • Nothing: all index funds are the same

  3. True or false: in the UK, holding an index fund in an ISA can protect its growth from UK tax.

    True or false?

  4. The market drops 20% in a month. What does an index investor’s plan usually say?

    • Sell everything now
    • Stop paying in until it recovers
    • Switch to an active fund
    • Keep investing as planned, unless your goals have changed

  5. What should you add up to find the total cost of an index fund?

    • The fund’s yearly charge plus the platform fee
    • Only the fund’s charge
    • The share price
    • Only last year’s return

  6. Your goal is 18 months away. What do the rules suggest?

    • Move part of the money into bonds or cash
    • Do nothing ever
    • Switch to one country’s index
    • Put more into shares

Level 4: Numbers and costs

  1. You hold £10,000 in a fund charging 0.9% a year. How much is the charge in the first year, in pounds?

    Type a number (a year).

  2. Same £10,000 in a tracker charging 0.1% a year. How much is the charge in the first year, in pounds?

    Type a number (a year).

  3. Fund A charges 0.1% and Fund B charges 0.9%. By how many percentage points must Fund B beat the market each year, before trading costs, just to match Fund A?

    Type a number (points).

  4. After 30 years, £10,000 reaches about £55,800 with a 0.1% fee and about £43,200 with a 1% fee. What is the gap, in pounds?

    Type a number.

  5. A scorecard says 94% of funds lagged their benchmark. What percentage did not lag?

    Type a number (%).

  6. A fund charges 0.2% a year and your platform charges 0.25% a year. What is your total yearly cost, in percent?

    Type a number (%).

  7. Your total yearly cost is 0.45% and you hold £20,000. How much do you pay this year, in pounds?

    Type a number (a year).

Level 5: Judge the evidence

  1. A fund beat its index over the last three years. What does the research suggest you can conclude?

    • Its manager is a genius
    • Index funds are broken
    • Not much: short-term winners often don’t stay on top
    • It will beat the index forever

  2. Why is Sharpe’s point called arithmetic rather than a forecast?

    • It only works in maths lessons
    • He used a calculator
    • It follows from definitions: active plus passive equals the market
    • It’s a guess about the future

  3. True or false: if almost everyone switched to index funds, Sharpe’s arithmetic would stop being true.

    True or false?

  4. Which is the strongest reason a beginner might still choose an index fund over a promising active fund?

    • Index funds always win
    • Active funds are illegal
    • Lower costs are certain, while an active fund’s extra return is not
    • Index funds never fall

  5. An index is 40% in its five biggest companies. What does that mean for you?

    • Owning “the market” means owning a lot of a few names, so it’s less spread out than it sounds
    • The fund is active
    • Nothing: it’s fully diversified
    • It can’t fall

  6. What should you have in place before investing in an index fund?

    • Emergency savings in cash
    • An active fund as well
    • A tip from social media
    • A bigger fund fee

  7. Over 10 years, 94% of European equity funds lagged their benchmark. What is the fairest reading?

    • Nobody should invest
    • Most active funds didn’t beat a simple index after costs, so picking one that will is hard
    • Every active fund is bad
    • Index funds made 94%

  8. Why might a single-country index fund be riskier than a global one?

    • It has lower fees
    • It can’t fall
    • It’s less spread out, so one country’s problems can hit it hard
    • It holds more companies

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