Editor’s note: This is an educational explainer about how index funds generally work. It is general information, not investment advice, and does not describe any specific current event, company, or security.

“Passive investing” is one of the more misleading phrases in finance. It suggests a fund that simply sits still, mirroring a benchmark like the FTSE 100 without any ongoing effort. In practice, a fund manager running an index tracker is doing something continuously — just not the thing most people imagine.

Two Ways to Copy an Index

The most literal approach is full replication: the fund buys every constituent of the index, in exactly the proportion the index specifies. For a benchmark like the FTSE 100, with a manageable number of large, liquid constituents, this is straightforward enough. It becomes far harder for indices with thousands of components, many of them thinly traded — buying the smallest, least liquid names in precisely the right weight can be expensive and, at times, close to impractical.

That’s where sampling comes in. Rather than buying every constituent, the fund buys a representative subset, statistically constructed to behave like the full index without literally owning all of it. This introduces something called “tracking error” — the gap between what the fund actually returns and what the index itself returns. A well-run sampled fund keeps that gap small, but it is never structurally zero the way full replication is designed to be.

The Rebalancing Problem Nobody Advertises

Indices themselves aren’t static — constituents get added, removed, and reweighted, whether because a company’s market capitalisation crossed a threshold, it was acquired, or the index provider revised its methodology. Every one of those changes forces tracking funds to trade, often on the same day, in the same direction, as every other fund tracking the same benchmark.

This predictable, synchronised trading has a name — “index effect” — and it’s well documented in academic finance literature: stocks being added to a major index tend to see a price bump in the days around the change, partly because of exactly this mechanical buying pressure from tracker funds, independent of anything about the company’s actual prospects. It’s a curious inversion of what passive investing is often assumed to do: rather than being a neutral bystander to price discovery, index reconstitution days are moments when tracker funds collectively become a meaningful source of it.

What “Tracking” Doesn’t Mean

None of this means index funds fail at their basic job — for most investors, over long periods, a well-run tracker delivers something very close to the index’s return, minus its fee, and does so more cheaply and with less manager-selection risk than most actively managed alternatives. But “tracks the index” is a mechanical description of a fund’s process, not a guarantee about outcomes, and the small, structural frictions described above — sampling gaps, rebalancing costs, the fee itself — are the reason a passive fund’s return is never perfectly identical to the index it’s named after.