How index funds work: why doing nothing beats most experts
How an index fund keeps up with the S&P 500 without buying or selling
The biggest American companies grow and shrink every day, and an S&P 500 index fund keeps up with every one of them. Yet it almost never needs to buy or sell. How does it keep up?
-
1
The 500 companies of the S&P 500 are not the same size. The biggest one is worth about a thousand times more than the smallest. So how much of each one should your fund own?
-
2
Each company has a number of shares, and each share has a price. The price of one share times the number of shares is what the company is worth on the market. This is its market value.
-
3
Your index fund gives each company a part of your money that matches its market value. A company that is 5% of the whole market gets 5% of your money. Your fund is a tiny copy of the market.
-
4
Now that company's share price doubles. Its slice of the market grows. Its slice of your fund grows too, by itself, because you own its shares. Your fund still matches the market, and nobody had to buy or sell.
-
5
Rono's team works the other way. All year, they sell some shares and buy others, to move money toward the companies they like best.
-
6
Your index fund trades only when the list itself changes. Now and then, a company leaves the S&P 500 and another one takes its place. Then the fund swaps those two, and that is all.
-
7
In June, the first two statements go up on the noticeboard. Rono's fund made 10%. Your fund made 7%, almost exactly what the market made. Miva is ahead.
-
Quick check
A company that falls.
Show the answer
No. Its slice of your fund shrinks by itself, just as its slice of the market does, so the fund still matches the market.
-
Go further
Two words for what you saw.