How do index funds follow their indices?



Since an index fund is ran by a separate company to follow a market index (like the S&P 500), and is not actually the index, how does it match the index movement?

I know the fund managers buy shares of stock represented by the index. But it’s a separate stock that can be traded by investors, so it can take on a trend of it’s own right?

In: Economics

An index fund is basically a basket of stocks from a certain index. The companies that create these funds buy the stocks in the index at different percentages so that the fund itself will mimic the same movements as the index it tracks. This way, if say, Amazon takes off because of great earnings, it doesn’t skew the fund’s price upwards because all the other stocks will smooth out the price movement.

The index vendor licenses to the fund manager a “recipe” — buy X% of this stock, Y% of this stock, and so forth — which also happens to be the **definition** of the index itself.

Thus, if properly constituted, the fund has NO CHOICE but to follow its index, since it is defined in the same way.

SOME types of funds are subject to “drift”, but there is also a self-correcting mechanism built into the creation-of-shares process.

you just look up how the index is defined, i.e. which company at which relative weight.
You then copy that definition and put the shares into your basket at the same relative weights.
That’s all the work you need to do, all in the beginning. It will then have the same performance (minus market fees).

You only really need to adjust your basket when the index definitions change (companies dropping in and out, or weights change)

There are two types of index funds–mutual funds and ETFs.

Mutual funds are not “a separate stock”. They don’t trade throughout the day. They only trade once a day while the markets are closed, and trade at the NAV (net asset value) computed based on the closing prices of all the stocks it contains. So it can’t have a trend of its own.

ETFs do trade like stocks. They can develop a trend of their own, but there are “authorized participants” who can break a large block of ETF shares into the proper number of shares of all the underlying stocks, or the other way around. If the ETF trended too far away from the aggregate of the shares it holds, then the authorized participants can make money by doing this trade in whichever direction makes sense, and by doing so they will correct the trend.