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An index fund tracks the underlying index. So if one invests 100 $ in an index fund tracking S&P 500, and the index grows 8 % in a year, will the 100 $ grow to 108 $?
If not, how can the investor predict the earnings for his investment?

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3 Answers 3

up vote 7 down vote accepted

An index fund tracks the performance of an index by investing in securities in the benchmark in the same proportions as the benchmark. The funds track their indexes pretty closely, with the following factors contributing to deviations:

  • Dividends. Some indexes exclude the dividends in their numbers, while the fund invested in the stocks of the index earns dividends. This helps the fund outperform the index.

  • Cash. Because of redemptions and contributions, some of the fund's funds are in cash rather than securities. Example: if 5% of the fund is in cash, only 95% is subject to growth or decline. If the market goes up 1%, the fund's value goes up 0.95%. Similarly if the market goes down 1% the fund loses 0.95%. This helps the fund outperform in bad markets and underperform in bad markets.

  • Fee: the fund incurs expenses for management, infrastructure, administrative fees, etc. The index is a theoretical portfolio. This hurts the fund's performance relative to the index.

  • Trading: Funds incur trading costs any time contributions or redemptions occur. Also some indexes are rebalanced frequently, causing funds that follow them to trade more frequently to keep matched to the benchmark. This hurts performance.

  • Benchmark deviations: While the funds attempt to mirror the index, they can never do it 100% at all times due to market fluctuations, purchase timings, etc. This can either hurt or help the performance of the fund.

Hope this helps.

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In the case of a index such as the S&P and its largest ETF, SPY, the fees are deducted from dividends, with a current yield of 1.73% and expenses of .09%, there's little risk the dividend wont be sufficient to cover the expenses. The ETF price should track the S&P very closely, the total return in a given year should be close to .09% less than the index total return.

On the other hand, there are ETFs that don't quite do the job tracking that they might. I wrote a piece on this titled ETF'ed in which I describe one such product.

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Yes, it will grow the same as the underlying fund minus the fund fees which is usually something like couple percent the whole fund property every year, so the fund actually grows less than the index.

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1  
It 'should' grow the same; or nearly the same, depending on how well it tracks the index. –  ChrisW Jun 14 '11 at 13:28
    
@ChrisW: Yes, but don't forget the fees - the management company want money too. –  sharptooth Jun 14 '11 at 13:29

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