How does a fund follow an index?

Question

I've phrased this question in an ELI5 manner setting the stage with a list of basic Q&A's to build the foundation, and ending with an actual question.

[Q] What is S&P 500?

[A] S&P 500 is an index tracking the top 500 US companies.

---

[Q] What is an index?

[A] An index is a number calculated to represent/track a certain subset of a market. A subset of a market can be - "top 1000 Asian tech companies", "top 100 EU companies", "top 10 mining companies"

---

[Q] Who decides which "top 500 US companies" get on the list?

[A] The S&P people come together and calculate. They calculate the market cap of each company and make a list of 500 best. A market cap is: stock price X number of stocks.

---

[Q] How to you get from "top 500 market caps" to a single number?

[A] You average it across all companies and further divide it by a divisor. The presence of the divisor is the reason the S&P 500 index isn't in dollars

---

[Q] How do I invest in the S&P 500?

[A] You can't. It's just a number. However you can buy shares of a fund which is following that index.

---

That sums up the Q&A now the questions I don't know the answer to:

• What does it mean that a fund follows an index?
• How does a fund following an index decide on the ratio of the stocks to buy?
• What happens with dividends?
• How does the fund act if the index divisor changes, or the list of companies in the index changes?

Answer 1

What does it mean that a fund follows an index?

It means that the price of the fund maintains a fixed ratio to the index (up to a small "tracking error"). For example, the price of the SPY ETF has consistently remained about 0.1 times the S&P 500.

How does a fund following an index decide on the ratio of the stocks to buy?

The fund buys stocks according to the definition of the index. The S&P 500 is market-cap weighted. Let's say the total assets of the fund equal 0.03% of the total market cap of the S&P 500 stocks. Then the fund buys 0.03% of the outstanding shares of each stock. This ensures the fund's value will follow the S&P 500. The fund only needs to "rebalance" (buy or sell stocks) when the composition of the S&P 500 changes (a company is added or removed).

What happens with dividends?

The fund receives dividends from the stocks it holds, and passes the dividends to the fund shareholders quarterly (typically after taking out the fund's management fees). It is each shareholder's choice whether to reinvest the dividends or not.

How does the fund act if the index divisor changes, or the list of companies in the index changes?

Part of the point of designing an index is that the divisor will change only when the composition (list of companies) changes. The fund buys and sells stocks as needed to reflect the index update.

Answer 2

What does it mean that a fund follows an index?

The index maker defines the recipe of the companies to include in the index, the mutual fund just follows that recipe.

How does a fund following an index decide on the ratio of the stocks to buy?

The recipe used to calculate the index value, tells the mutual fund the proportion to buy the shares. As new money flows into he fund, or existing shares are sold when money exits the system, the fund buys or sells shares of the companies to try and stay in close agreement with the recipe.

When the company that defines the index makes changes to the makeup of the index, then the fund has to make adjustments to match the change. This happens when there is a merger or a company splits, and also periodically as the economy changes. Some index companies review the makeup of the index on a set schedule.

What happens with dividends?

They go to the people that own the fund shares. Some people re-invest them, some use them as income to live off of, others use them to invest in other things.

How does the fund act if the index divisor changes, or the list of companies in the index changes?

when the recipe changes, the fund makes the same changes.