Advantages and disadvantages of index funds
Last Updated on 3 February 2026 by Equipo Urbanitae
Investment in index funds that track an index such as the S&P 500 has grown in popularity over recent decades, attracting both novice and experienced investors. Instead of trying to beat the market, they aim to match its returns by buying the securities in the index in the same proportions. This investment strategy, known for its simplicity and cost efficiency, offers an effective way to participate in the growth of the financial markets. In this article, we explain what the main advantages of investing in index funds are.
Advantages of index funds
As John Bogle says, “the winning formula for success in investing is to own the entire stock market through an index fund, and then do nothing. Just stay the course.” Simplicity is the main advantage of passive management funds, but there are more.
Diversification
Index funds provide broad diversification. By investing in an index fund, you are buying a fraction of all the companies that make up the index. This reduces the specific risk associated with any individual company.
Low maintenance costs
One of the most notable advantages of passive management funds is their low operating costs. Since they follow a passive strategy and do not require the active management of a team of analysts and managers, index funds typically have much lower fees than actively managed funds.
Competitive performance
“Under normal circumstances, it takes between twenty and eight hundred years to statistically prove that a manager is skillful, not lucky. To have 95 percent confidence that a manager is not just lucky, it may easily take nearly a millennium, which is much longer than most people have in mind when they say ‘long term.’” These are the words of Ted Aronson, founder of the fund management firm AJO.
Historically, many index funds have matched or exceeded the performance of actively managed funds. Due to their low costs and the difficulty of consistently outperforming the market, passive management funds have proven to be an effective long-term investment option.
Transparency
Index funds are very transparent. Investors always know what they are investing in, as the components of the index are public and rarely change significantly.
Ease of management
For investors looking for a simple way to invest, index funds offer a practical solution. There is no need to worry about selecting individual stocks or timing the market.
Disadvantages of index funds
Passive management is very convenient for the investor, but giving up decision-making has some drawbacks.
Lack of flexibility
Passive management funds lack flexibility to adapt to changing market conditions. Since they replicate an index, they cannot dispose of stocks of poorly performing companies, nor can they take advantage of emerging opportunities that an active manager might identify – although we know this rarely happens.
Limited returns
By following an index, index funds can only aspire to match the market’s performance, never exceed it. This could be a disadvantage compared to actively managed funds, which aim to generate superior returns.
Total market exposure
The diversification in passive management funds means that investors are exposed to the entire market, including both its positive and negative aspects. In times of recession or financial crisis, index funds can suffer significant losses.
No individualized strategies
Index funds do not allow investors to implement individualized strategies. For example, you cannot adjust the portfolio to focus on specific sectors, investment styles (such as value vs. growth), or geographies, something that active management does allow.
The results demonstrate the long-term superiority of passive management funds. Warren Buffett himself made this recommendation in his letter to Berkshire Hathaway investors in 2016: “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
How to choose a good index fund?
Choosing a good index fund is simple if you focus on what matters: which market it covers, how much it costs, and how closely it tracks its benchmark. Then, choose the vehicle and tax treatment that suit you (mutual fund vs. ETF in Spain), check the product’s quality and liquidity, and fine-tune practical details such as trading and currency. With these five building blocks, you can make a consistent decision in very little time:
Market coverage
- Choose a broad, representative index such as the MSCI World, ACWI, etc.
- Avoid duplicating regions and countries to maintain healthy diversification.
Costs and tracking
- A competitive TER for its category.
- A stable tracking difference that stays close to the index.
Tax treatment in Spain
- Choose a mutual fund if you prioritize tax-exempt transfers (“traspasos”); choose an ETF if you value intraday trading.
- An efficient domicile and a dividend policy aligned with your preferences.
Quality and liquidity
- Sufficient size and track record.
- Comfortable liquidity.
Trading and currency
- A euro-denominated share class and hedging (if relevant).
- Keep the true total cost under control.
If the fund you’re evaluating meets most of these criteria—especially index coverage, TER, tracking, and tax fit in Spain—you can consider it a good option for building a solid long-term portfolio. And if you want to go deeper, check out our guide to investing in funds.
Conclusion
Index funds are a simple, diversified, low-cost way to participate in the market: they don’t aim to beat the index, but to replicate it with discipline. In exchange for accepting the volatility inherent to equities, they offer an efficient tool to build long-term wealth with less friction and fewer decisions.
Frequently asked questions
What fees does an index fund charge besides the TER?
In addition to the TER, custody/depositary fees may apply and, depending on your platform, a service fee. If you invest via ETFs, add trading commissions, the bid–ask spread, and possible exchange fees—these are not charged by the fund itself, but they do affect your total cost.
Is an index fund or an ETF better?
It depends on your priority: a mutual fund is often better if you want tax-exempt transfers and simplicity, while an ETF fits if you want intraday trading and more control over orders. Keep in mind that, generally, ETFs do not allow tax-exempt transfers in Spain.
How many funds do I need to diversify well?
For most people, 1–3 is enough: a global equity fund as the core, and optionally global bonds to reduce volatility.
What TER is considered competitive?
As a rough guideline: 0.10%–0.20% for US/Europe equities, 0.20%–0.30% for global equities, and 0.15%–0.25% for global bonds. Don’t look only at the TER—also check the tracking difference and the true total cost.
