Why Does Index Fund Performance Not Match the Index?

When looking at index fund performance, you might notice that the actual return of an index fund is not exactly the same as the index that tracks. While index funds aim to match the performance of a particular index, that does not always occur. In fact, they are generally a little bit behind the index as a whole. Here are a few reasons to consider why this might happen.

Expenses

One reason that your index fund will not return exactly the same as the index is because of the expenses involved. In order to provide you with the opportunity to invest in a mutual fund, the mutual fund company has to charge you an expense ratio. This ratio pays for the mutual fund managers salaries as well as the other administrative costs of the fund. While this may not seem like much, every amount that is taken out of the returns for expenses, is a little less money that you get to keep. Some mutual funds are better than others when it comes to charging expenses, but they all have to charge something in order to cover costs and make a profit.

Arbitrage

Another reason that some mutual funds do not match the exact performance of the index is because of the arbitrage that sometimes occurs with this type of investing. With a financial index, you have a list of stocks that are included in the index. When conditions change, companies are taken out of the index and other companies are added into it. For example, with the S&P 500, when a company falls out of the top 500 companies they will be removed from the index. At the same time, the companies that overtook them in this ranking will move up into the index. When this happens, every index fund that tracks that particular index has to simultaneously sell the stocks that were removed from the index and buy the ones that were added. 

Some mutual funds attempt to calculate which companies will be added to the index in advance and buy the stocks in advance. If they are right, they can benefit from a bump in the stock price when all of the other index funds make their purchases. If you are in one of the index funds that came in late to the purchase, the price of the stocks will be a little bit higher which will cost you some in return. 

Execution

Another reason that index fund performance can lag behind the market is because of a lack of execution on orders. When an index fund makes a purchase, they have to buy thousands of shares at the same time. In some cases, brokers cannot fill a larger order like this at once all the same price. Because of this, some of the shares might be a little more expensive than others. This will cut into the amount of returns that are generated and can affect the performance. 

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