Index and tracker funds are a multi-trillion dollar market, letting investors replicate the performance of a particular market or asset class – but how do they work?
Index funds have been around for decades. They are a low-cost way to diversify a portfolio or gain exposure to a sector or theme. Index trackers are often among DIY investors’ top fund picks as they offer value for money, low fees and reliable market-level performance.
They replicate a specific market index, such as the FTSE All-World or the FTSE 100, by holding all or a representative sample of the stocks or bonds within that index.
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“Rather than attempting to beat the market, index funds aim to match it, offering predictable returns and minimal management costs,” says James Norton, head of retirement and investments at Vanguard Europe. As such, they represent a passive as opposed to active investment style.
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The first ever index fund that was available to retail investors was the Vanguard 500 Fund, introduced in 1976 by Vanguard’s founder John ‘Jack’ Bogle. Bogle is often viewed as a pioneer of index investing, and nearly 50 years on the Vanguard 500 Fund still tracks the returns of the S&P 500.
They have stood the test of time, with index-tracking equity funds registering net retail inflows of £1.1 billion in January 2026 according to data from the Investment Association. They are popular both with beginner investors and with more experienced hands as they provide convenient exposure to a wide variety of assets.
Advantages and disadvantages of index funds
There are four key benefits of index funds, according to Norton. These are:
Low cost: By avoiding the high fees often associated with active management, index funds help investors retain more of their returns.
“In many areas of life, higher costs are correlated to a better product,” says Norton. “However, with investing, high cost is simply a hurdle for the manager to beat simply to break even. Data suggests that index funds outperform more expensive active funds over both the short and longer-term.”
Diversification: Broad exposure across sectors and geographies helps manage risk effectively. Investors who hold a diversely-invested index fund will by default own the best performing stocks. As Jack Bogle said, “Don’t look for the needle in the haystack, just buy the haystack.”
Transparency: With index funds, investors know exactly what they own and how it performs.
Discipline: Index funds encourage long-term investing and reduce the temptation to try to time the market.
However, Norton adds that investors should consider the following principles when investing using index funds:
- Define clear goals: Align investments with long-term objectives.
- Maintain balance: Diversify across asset classes and regions.
- Minimise costs: Prioritise low-fee index funds to maximise net returns.
- Stay disciplined: Avoid reactive decisions during market fluctuations.
What makes index funds reliable?
Index funds track an index of assets (which is why they are often referred to as ‘tracker funds’). As long as they are managed correctly, their returns will always match those of this ‘benchmark’ index.
That makes them a relatively reliable way of gaining exposure to a given market or theme, as long as the underlying index is a good representation of the market. The fund manager will ensure that the mix of assets within the portfolio reflects those in the benchmark index.
This is in contrast to active funds, where the fund manager will proactively buy and sell assets into and out of the portfolio in an attempt to outperform the benchmark.
In theory, that means investors can realise higher returns by investing in active funds than index funds for equivalent sectors, but that often doesn’t happen in reality. AJ Bell’s latest Manager versus Machine report found that just 24% of active funds outperformed a passive alternative during the 10 years to 30 November 2025.
So if investors want to allocate a portion of their portfolio to match the returns of the global stock market, their most reliable option would be a global equities index fund (tracking, for example, the MSCI World Index).
Index funds are, however, subject to ‘tracking error’, which refers to the variance between their returns and those of the benchmark index.
“Investors should check how tightly the fund tracks its index,” says Dan Moczulski, managing director at eToro UK. “The lower the tracking error, the better.”
The most popular index funds to buy now
During the first two months of 2026, these were the most popular index funds among AJ Bell’s DIY investors:
Source: AJ Bell, Dodl. Based on net buys during January and February 2026.
While the list includes two S&P 500 trackers and five global stock market trackers, there is also the L&G Global Technology Index Trust which is one example of how index funds can be used to gain exposure to a specific sector or theme. The fund tracks the FTSE World – Technology Index, and as such offers investors exposure to a global selection of technology stocks.