What does it mean for an index fund to “track the S&P 500”?
In: 5
An index is just a list of companies, you can write down your own right now. An index fund is a fund that contains shares of the companies in said list.
More like an ELI15:
The S&P 500 index tracks 500 select stocks weighted by market capitalization, which is the total number of shares the company has issued times the stock price. So, for example, AAPL may represent 1.00% of the index. If AAPL’s stock price moves up a little bit and all the other 499 stay the same, AAPL may now represent 1.01% of the index.
The S&P 500 isn’t a product you can invest in; it’s a metric calculated by Standard and Poor (S&P). So many companies create their own product (ETF, mutual fund) to mimic the S&P 500 as closely as possible. This requires regular buying and selling of the 500 stocks to keep track as closely as possible with the changing market capitalizations (read: stock price) of the 500 stocks. E.g., in the AAPL example above, the fund manager would need to buy more AAPL stock to reflect its larger representation of the index. Note that such buying and selling that the fund manager is doing is not because of their views of the value of the stocks but merely to track the index as closely as possible. This is an index (or passive) fund.
A company called S&P (Standard and Poor’s) tracks the largest companies in the world. The term “S&P500” means the 500 largest companies.
An index fund effectively goes out and buys 1 share of each company on this list. So now whenever the values of companies on that list changes, the value of the fund also changes. ***Note****: this is oversimplified, and technically not how it works in reality, but I think this would help a 5 year-old understand the mechanics better.*
The idea is that it’s much easier for you to go buy 1 share of the index fund than it is for you to go buy shares from 500 companies separately. The fund handles the paperwork for you and charges you a small fee to cover the trading costs.
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