How an index fund worksHow an index fund works

Let’s look at what this means in practice, and why index funds that track the same index sometimes have different returns.

What’s an index?

Put simply, an index is a list of investments that boils down to a single value.

An index provider, such as S&P Dow Jones Indices who run the S&P 500 Index, sets the rules for what investments are listed in an index. You might have heard of these well known ‘indices’ (or ‘indexes’, depending on your preference): 

• S&P 500 Index which includes 500 large US-listed companies

• Dow Jones Industrial Average which includes 30 large US-listed industrial companies 

• S&P/NZX 50 Index which includes 50 large NZ-listed companies

• S&P/ASX 200 Index which includes 200 large ASX-listed companies. 

There’s plenty of others too! And they all track different groups of investments based on different sets of rules. 

How weighting is calculated

The index provider sets the weighting of each investment in the index—in other words, how much any one investment in the index can affect the overall value of the index. 

S&P 500 Index

The S&P 500 multiplies the share price of each of the 500 companies in the index by the number of shares it has available for public trading—this gives each company’s free-float market capitalisation, a measure of its size. This is then divided by the ‘Divisor’, a number that’s adjusted to keep the value of the index consistent—even as companies go through corporate actions. The result is the weighting factor for each company in the index. 

Weighting by free-float market cap means that movements in the share prices of large market cap companies tend to have a bigger impact on the index’s value than movements in the share prices of small market cap companies. 

Dow Jones Industrial Average

Compare the S&P 500 weighting to that of the Dow Jones Industrial Average. It adds up the share price of 30 companies, and simply divides it by a magic number called the ‘Dow Divisor’. It doesn’t account for a company’s free-float market cap. 

This means if a company has a small market cap but a high share price, changes in that share price will have a larger impact on the index’s value than a company with a large market cap but a low share price. 

Index funds

Here’s the thing about an index—you can’t actually invest in them directly, because they’re just a list. But, you can invest in index funds. 

Index funds are investments that track an index. An index fund will try to match the performance of a specific index by investing in the things on that index.

Index funds often have low fees, especially when compared to their close cousin, actively managed funds. Actively managed funds have fund managers who pick specific investments—and these people need to get paid! This often results in these funds having higher fees than index funds.

Index funds are passive. Since they just follow a set of rules, they tend to track the movements of the overall market. On the other hand, actively managed funds try to beat the market, which can give you lower or higher returns than the market depending on the fund manager’s investment choices. 

Why an index fund doesn’t always match its index

The thing to remember about index funds is that they’re based on an index, but they can’t always track it to a T. This happens for a few different reasons.

Tracking errors

Sometimes the investments within an index change! When a change happens, an index fund manager might need to buy shares in an investment that’s been added, or sell shares in an investment that’s been removed. This is called a rebalance.

If there are no sellers for a share the index fund wants to buy, or no buyers for a share the index fund wants to sell, the composition of shares it owns may end up differing from the index it’s tracking. This will make its returns different from that of the index. 

Fees

Index fund managers charge fees to cover their costs and to make a profit. These fees can vary wildly between different fund managers—even though they might be tracking the same index. These differences in fees can impact your returns.  

Weighting

An index fund might apply additional weighting that means their returns are slightly different from the returns of the index it tracks.

For example, the Smartshares NZ Top 50 Fund (FNZ) invests in the 50 largest companies listed on the New Zealand Stock Exchange (NZX). But it also applies weighting so that it never invests more than 5% of the fund’s total in any one company. This means it provides more equal exposure to the companies in the index, even though it’s not tracking the index precisely. 

The point is, different funds have different elements which can impact your returns—their weighting, fees, ability to track the market, and whether it’s hedged or unhedged.

Wrapping up

You can use index funds to diversify your portfolio and invest passively. But, not every index fund is created equal. That’s why due diligence is so important, even with ‘set and forget’ investments like index funds. 

Make sure you read up on the index fund you’re considering, compare it against your goals and values, then make a decision about what to invest in and how much to invest.