What is an index?

As we saw last time, most active' fund managers the ones who try to do better than the market fail. They don't beat the market, they underperform it. And because they charge substantial fees, they'll cost you a lot as well. In our view you're best off avoiding them.

The alternative is to buy a passive' fund. Instead of trying to beat a market, a passive fund just tries to copy it. So if you're bullish on a market in other words, you think it's going to go up then it often makes sense to invest in a passive fund.

There are various different types of passive funds, but they all share one thing in common: their goal is to track an underlying price. Usually this will be an index of some sort, such as the FTSE 100 or the Dow. Although some also track currency exchange rates or commodity prices for example, the price of gold.

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Before we look in detail at passive funds, there's one very obvious question we need to tackle: what exactly are these funds tracking? How does an index work?

Britain's most famous index: the FTSE 100

Most investors in Britain are very familiar with the name FTSE (pronounced footsie'). The FTSE 100 is one of the most widely-quoted stock market numbers on all our news programmes and in our newspapers.

The FTSE 100 is a stock market index. An index is simply a way of measuring the overall value of a range of companies or other assets, according to some underlying rules.

For the FTSE 100, the index is made up of the 100 biggest stocks listed on the London Stock Exchange. They are ranked by market capitalisation' (market cap), which is a simple way of working out their financial size. Market cap = the share price x number of shares outstanding.

The bigger the market cap, the bigger the portion of the index the company accounts for.In the jargon, the company has a heavier weighting'.

So if the price of the company at the top of the index moves, the impact on the FTSE 100 figure will be much greater than if the price of the 100th company in the index moves.

The FTSE 100 is not the only index of London-listed stocks. There's the FTSE 250 (the next 250 largest stocks) and the FTSE 350 (the FTSE 100 plus the FTSE 250).

Then there's the FTSE All-Share, which comprises more than 600 stocks in total, including the FTSE 350.

There are also various indices based on the Alternative Investment Market (AIM), which is theLondon Stock Exchange's market for smaller companies hoping to raise money to expand.

Beyond the UK, there are stock market indices for every major (and most minor) economies. In the US, the best known are the Dow Jones Industrial Average (30 of America's top companies) and the S&P 500 (the top 500 listed American companies).

Japan, meanwhile, has the Nikkei 225 (the biggest 225 stocks on the Tokyo Stock Exchange) and the Topix (which tracks around 1,700 companies).

There are also indices that track the price of commodities, and ones that track bond prices.

Watch out! Make sure you know what an index is doing

If you do decide you want to invest in a fund that tracks an index, it's extremely important to understand how the index works.

For example, basing an index on the size of the companies involved as the FTSE 100 does can give rise to some potential problems, or at least, misunderstandings.

If you buy a passive fund that tracks the FTSE 100, you might imagine that you are getting equal exposure to 100 different companies.

You're not. The top ten companies in the FTSE 100 account for more than 40% of its value (as of August 2012). And three of the topten are oil and gas companies. So in fact, you are making quite a concentrated bet on a small range of companies.

Now, this may be exactly the bet you want to make. But the point is, it's very important to understand what you're buying before you invest in anything.

Also, because companies become more dominant as their share price goes up (and their overall value rises), a FTSE 100 tracker fund actually buys more stock as a company gets more expensive, and sells as it falls in value. So instead of buy low, sell high', a tracker fund buys high, and sells low.

I should say that, even with this inherent problem, tracker funds still tend to beat actively managed funds.Which is an even more damning indictment of active funds!

There's more than one way to build an index

To make things more tricky, this is not the only method of compiling an index.

Some indices track individual sectors, for example. So if you want to invest in a range of stocks across the oil and gas sector, you might be better off buying a dedicated fund that does this, rather than the FTSE 100.

Other indices use different criteria to build the index. For example, there's a FTSE UK Dividend+ index. This takes the top 50 stocks by dividend yield. The higher the yield, the higher ranking the stock.

This creates its own problems: high dividend yields are not always sustainable, as we'll discuss in the future. But it does go some way to addressing the buy high, sell low' problem experienced by funds that track companies by market cap.

There's another FTSE 100-based index which caps the weighting of any individual stock at 5%. The idea is to create a more diversified index and get over the problem of the biggest companies completely dominating the index.

What to do now

In short, an index can be compiled for virtually any group of assets, and using a range of different rules. That means it's vital just as with an individual company to understand what the index is aiming to do and how it does it, before you invest in anything that tracks it.

So if you have any tracker funds in your portfolio just now, do make sure that you know exactly what those funds are giving you exposure to.