Index funds have become a core allocation tool for many investors. Learn how they work, why passive investing consistently outperforms active over the long term, how to compare leading funds, and the key risks to weigh before investing.
From Trying to Beat the Market to Choosing to Follow It
Index funds have grown from a relatively unfamiliar financial term into a core tool in many investors' asset allocation. Behind this shift lies a deeper change in investment philosophy: a growing number of investors no longer fixate on beating the market, but instead choose to follow its overall performance, participating in the fruits of economic growth over the long term through low-cost, highly transparent products.
The rise of passive investing is no accident. Morningstar's research shows that in 2023 passive funds overtook active funds in total net assets for the first time, and the gap has continued to widen since. In terms of long-term performance, it is quite difficult for active funds to outperform their passive counterparts consistently. Morningstar's data show that over the ten years to the end of 2025, only around 21% of active funds both survived and outperformed their passive counterparts. (Source: Morningstar, US Active/Passive Barometer Year-End 2025, published: 2026-02)
Defining Index Funds and Their Core Philosophy
The core philosophy of index funds is simple yet powerful: they do not actively pick stocks, but instead passively track a specific market index. Common benchmarks include the S&P 500, the Hang Seng Index and the CSI 300. This means that a fund's composition is largely identical to the constituents of the index, and its performance is closely tied to that of the market.
For newcomers just entering the world of investing, this approach reduces reliance on individual stock analysis and lessens the emotional interference in investment decisions. That said, investing is not purely theoretical. From becoming acquainted with an index fund, to actually placing an order, and then holding for several years, this process involves strategy selection, capital management and psychological preparation. Many people first familiarise themselves with market operations and fund volatility through a demo account, and only commit real capital once they have gained confidence.
Why Passive Keeps Winning Over Active
To understand the appeal of index funds, it is worth looking at a comparison of the recent performance of active and passive strategies. Morningstar's annual barometer offers a fairly authoritative observation, and the table below builds on it to set out the differences between the two across various dimensions.
| Dimension | Passive (index) funds | Active funds | Implication for investors |
|---|---|---|---|
| Investment approach | Tracks an index, replicating its constituents | Fund manager actively picks stocks | The passive approach reduces reliance on human judgement |
| Fee level | Generally low | Generally high | Fee differences significantly affect returns over the long term |
| Ten-year outperformance rate | Serves as the performance benchmark | About one in five active funds come out ahead | Beating the market over the long term is fairly difficult |
| Transparency | Holdings disclosed, close to the index | Holdings and strategy relatively opaque | Passive products are easier to understand and compare |
It should be noted that passive outperforming active does not hold true in every area. In structurally less efficient areas such as emerging markets and small and mid-cap stocks, active managers with genuine expertise may still generate excess returns. The two are therefore less opposites than complementary tools.
Comparing the Characteristics of Popular Index Funds
To help investors quickly grasp the differences between products, the following sets out several representative index funds, explained from three angles: the benchmark tracked, the expense ratio and market coverage.
Vanguard S&P 500 ETF (VOO): tracks the S&P 500 Index, with an expense ratio of just 0.03%. It focuses on large-cap US stocks and is one of the largest products of its kind, with assets under management approaching the trillion-dollar mark.
Vanguard Total Stock Market ETF (VTI): tracks a US total-market index, also with an expense ratio of 0.03%, covering more than three thousand large, mid and small-cap stocks, making it suitable for investors seeking whole-market exposure.
Vanguard Total World Stock ETF (VT): tracks a global equity index, with an expense ratio of around 0.07%, covering both developed and emerging markets and providing internationally diversified allocation.
Local-market index products: such as those tracking the Taiwan 50 Index or the Nikkei 225 Index, typically carry expense ratios of between 0.1% and 0.4%, allowing investors to position themselves in the large-cap stocks of a specific region.
These products show that, whether in local or international markets, index funds generally offer long-term performance close to the market, with expense ratios far below those of active funds. This is precisely one of the key reasons capital continues to flow into such products.
Risks and Real-World Challenges
No investment is a one-way, smooth path. While index funds carry relatively diversified risk, they are not risk-free. Viewing the following challenges rationally is a prerequisite for holding them over the long term.
Systematic downside risk: if the tracked market index suffers an across-the-board decline, the fund's net asset value will fall in step. Numerous global stock-market corrections in the past show that even the most diversified portfolio can bear considerable unrealised losses in extreme conditions.
Differences in fee structure: passive funds generally have lower expense ratios than active funds, but management fees still vary between fund companies. In the US market, for instance, some low-cost products have expense ratios as low as 0.03%, while certain comparable products sold by banks may exceed 0.5%.
Fee erosion under compounding: do not underestimate that difference of a few tenths of a percentage point. Under long-term compounding, a fee difference can accumulate into a considerable sum, directly affecting the final return.
Trading and currency-conversion costs: when investing in cross-border products, platform trading costs and currency-conversion fees also erode returns, and should be taken into account when selecting products.
For these reasons, strategies such as long-term holding and regular fixed-amount investing are often regarded as effective ways to cope with market volatility, and are points that many professional investment advisers emphasise during a first consultation.
Developments and Investment Opportunities in the Chinese-Speaking Market
In the Chinese-speaking market, particularly Hong Kong and mainland China, the development of index funds is gathering pace. Technology-index products on the Hong Kong Stock Exchange and CSI 300-related products in the A-share market have both become focal points for capital. Passive products account for a relatively high share of the listings on local exchanges, reflecting investors' preference for transparent, low-cost tools.
For investors looking to diversify their allocation, this means a wider range of choices and greater liquidity, and makes building a core portfolio around index funds a genuinely viable strategy. When switching between US dollar-denominated international products and region-specific products denominated in local currency, investors need to be mindful of the impact of exchange-rate movements on overall returns.
Frequently Asked Questions on Index Funds
Are index funds suitable for short-term investing?
Generally not advisable. The strength of index funds lies in tracking market performance over the long term, and in the short term they are readily affected by market volatility. Unless you have a clear short-term trading strategy and risk controls, they are better suited to being held over the medium to long term.
How should a beginner start investing in index funds?
For beginners, it is advisable to first familiarise yourself with the operational process and fund characteristics using a demo account before committing real capital. Choosing products with low fees, high liquidity and small tracking error, and setting out a long-term plan, is a fairly prudent way to start.
Can an index fund go bankrupt?
An index fund is not itself a company and cannot go bankrupt through poor management. Even if the fund management company runs into trouble, the fund's assets are usually held by an independent custodian, providing a relatively high degree of legal protection. The greatest risk still comes from market volatility itself.
Why do passive funds often outperform active funds over the long term?
The core reasons are fees and efficiency. Passive funds generally have lower expense ratios and, under long-term compounding, retain more of the return; at the same time, most active managers find it hard to make consistently market-beating judgements. Morningstar data show that over a ten-year horizon, only around one in five active funds outperform their passive counterparts.
Can a tiny difference in the expense ratio really affect long-term returns?
Yes, and the effect can exceed intuition. Take expense ratios of 0.03% and 0.5% as an example: the gap may seem small, but under the compounding of several decades it can develop into a considerable difference in returns, so fee structures should be compared carefully when selecting a product.
