What You Actually Own When You Buy An Index Fund

For about four years I owned an index fund and could not have named six things inside it. I knew the phrase 500 companies and I knew it was supposed to be the safe, boring, do-nothing choice, and I treated the fund like a savings account with better weather.

Then a colleague asked me what percentage of it was in technology and I realised I had no idea whether the honest answer was 8% or 35%.

An index is a rule, not a thing

An index is a published set of instructions. It says which companies qualify for the list, how often the list gets reviewed, and how much of the list each company is entitled to. A committee or a formula applies those instructions and publishes the result.

The index itself owns nothing. It is a scoreboard.

An index fund is a portfolio that goes out and buys the actual shares in the proportions the rule specifies, so that its value moves the way the scoreboard moves. You are not buying the index. You are buying a fund that has promised to copy it, and it charges you a fee for the copying.

What weighted means

Almost every well known stock index weights by market value, sometimes called market capitalisation, which is just the share price multiplied by the number of shares outstanding. A company worth $3tn gets three times the space that a company worth $1tn gets.

The arithmetic is a division problem. Each company's share of the fund is its market value divided by the combined market value of everything on the list.

Five companies, and two of them hold 71.5% of your money. Nothing about that is a flaw in the fund. It is the rule doing exactly what it says it does.

Scale that logic to 500 names and the shape survives. The list is long, the weighting is not flat, and the largest handful of companies routinely account for a very large share of a big US stock fund. The exact figure moves every day, which is why the number I would print here is useless and the number on your fund's own page is not.

Go look at the top ten

Every fund publishes a holdings page. It lists the top ten positions, the percentage each one represents, and the sector breakdown underneath. It takes about ninety seconds to read and it is the only honest answer to the question of what you own.

Two things to check while you are there. First, what share of the whole fund the top ten adds up to. Second, whether the same three or four names also dominate the other fund you hold, because owning two funds that hold the same top ten is not the same as owning two things.

That second one caught me. I had an S and P 500 fund and a large-cap growth fund and felt organised about it, and the overlap between them was substantial.

Who decides what goes on the list

For some indexes, a formula does it. Take every listed company, rank them by size, keep the top thousand, rebalance quarterly. No judgement anywhere in the process.

For others, a committee does it. The best known US large company index is maintained by one, applying published criteria that include profitability, how much of the stock is actually available to trade, and how long the company has been listed. A company can satisfy every numerical test and still not be added.

That is a mildly uncomfortable fact about something people describe as passive. Somebody is choosing, and the fund you own has agreed in advance to buy whatever they choose.

It also carries a cost. When a company joins a widely tracked index, every fund tracking that index has to buy it at roughly the same moment, and buying alongside a crowd is not how anyone gets a good price.

Equal weight, and why it is different

There is another rule you can buy. An equal weight fund holds the same 500 companies and gives each one the same slice, so every name gets 0.2% and the smallest company matters exactly as much as the largest.

That sounds fairer and it behaves differently, not better. Equal weight has to keep selling what went up and buying what went down to stay equal, which means more trading, usually a higher fee, and a return that pulls away from the headline index in both directions. A cap-weighted fund never has to rebalance for price moves at all, because when a company doubles its weight in the index doubles on its own.

That self-adjusting property is a large part of why cap-weighted index funds are cheap. Less trading, fewer decisions, a smaller team.

500 is not the market

A 500 company index covers the large end of the US stock market. It leaves out thousands of smaller listed US companies and every company headquartered anywhere else in the world.

A total US market fund holds the small and mid-sized names too. Because it is weighted by market value, adding several thousand small companies shifts the result less than you would expect, since all of them together make up a modest slice of the total value. The overlap with a 500 company fund is high and it is not complete.

International is the bigger gap. A US-only fund holds none of the companies listed elsewhere, and depending on how you measure it those are somewhere between a third and a half of global market value. Whether you want that exposure is a real decision, and most people make it by accident.

The fee is the other half of what you own

An expense ratio is the annual slice the fund takes off the top, quoted as a percentage of your balance. On $100,000, a fund charging 0.03% takes $30 a year and a fund charging 0.71% takes $710.

Both of those funds can be tracking the identical index, holding the identical companies, at the identical weights. The rule is public. Copying a public rule is not hard, and the price of the copying varies by a factor of twenty.

Open your fund's holdings page and write down two numbers: the top ten as a percentage of the fund, and the expense ratio. Then check them against any other stock fund you own. If the top tens are the same names and one fee is ten times the other, you have found something worth an afternoon.