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An S&P500 index fund will hold each of the 500 stocks that are in the S&P 500.

Does it target holding an equal number of shares of each stock? An equal dollar amount? Does this vary based on a particular index fund or what the fund is mirroring?

I found this question: How does an index rearrange its major holdings

That question seems to be what an index fund does after it's out of balance. I'm curious how it knows it is in balance.

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4 Answers 4

up vote 7 down vote accepted

In general, the goal of an S&P 500 index fund is to replicate the performance of the S&P 500 Index. To do this, the fund will buy the same stocks in the same proportions as the weighting of the Index.

The S&P 500 Index is free-float capitalization weighted. This means that the higher capitalization stocks (based on publicly traded shares only) are more heavily weighted and factor into the Index value more heavily than the smaller capitalization stocks, or the stocks that have a smaller publicly traded value. For example, companies like Apple, ExxonMobil, and Microsoft have a much larger weight in the index value than smaller companies.

Alternatively, there are some S&P index funds that are equal-weighted. In these funds, the managers have chosen to purchase all 500 of the stocks in the index, but in equal proportions instead of the weighted proportions of the index. These equal-weighted funds will not as closely match the index price as the traditionally weighted index funds. Instead, they might do better or worse than the index, depending on how the individual stocks do.

You'll need to look at the prospectus of the index funds you are interested in to see which approach the fund is taking.

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An index fund is just copying the definition of an index. The group that defines the index determines how to weight the different parts of the index. The index fund just makes sure they invest the same way the index creator wants.

Think of a non-investment scenario. A teacher can grade tests, quizzes, homework, in-class assignments, research papers. They decide how much weight to give each category and how much weight to give each part of each category.

when a student wants to see how they are doing they take the information in the syllabus, and generate a few formulas in a spreadsheet to calculate their current grade. They can also calculate what they need to get on the final exam to get the grade they want.

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Yes, it depends on the fund it's trying to mirror. The ETF for the S&P that's best known (in my opinion) is SPY and you see the breakdown of its holdings. Clearly, it's not an equal weighted index.

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Note that an index fund may not be able to precisely mirror the index it's tracking. If enough many people invest enough money into funds based on that index, there may not always be sufficient shares available of every stock included in the index for the fund to both accept additional investment and track the index precisely.

This is one of the places where the details of one index fund may differ from another even when they're following the same index. IDEALLY they ought to deliver the same returns, but in practical terms they're going to diverge a bit.

(Personally, as long as I'm getting "market rate of return" or better on average across all my funds, at a risk I'm comfortable with, I honestly don't care enough to try to optimize it further. Pick a distribution based on some stochastic modelling tools, rebalance periodically to maintain that distribution, and otherwise ignore it. That's very much to the taste of someone like me who wants the savings to work for him rather than vice versa.)

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as long as I'm getting "market rate of return" or better on average across all my funds I was under the impression that it's not possible to do this consistently due to fund expenses and transaction costs. – Michael Mar 2 at 5:47
It's certainly possible to exceed the market's overall average; every bad investment you can rule out raises the average of the remainder. Fund expenses vary from fund to fund, and are minimal on a good ndex fund (fraction of a percent yearly, no transaction fee as long as you aren't doing an unreasonable number of transactions per month). – keshlam Mar 2 at 22:50
when you own an index you can't rule out bad investments because you don't have any control over what the fund invests in. if you are referring to a specific fund that outperforms an index, i still don't think you can outperform the market risk adjusted: that would mean you are outperforming your benchmark; i was under the impression that to do this consistently isn't really possible. And even underperforming by 0.5% over 30-40 years can still add up. – Michael Mar 2 at 22:58
Sure you can. Index is not necessarily a blind sampling; they make that decision initially when they decide which index the fund will track, and continue to make it as the software manages the details of the fund's holdings. For example, an index which tracks the fortune 500 has made decisions about risk vs. return and you pick up that bias when you buy into it. Ditto other indexes; if you want to do this "properly" you should check out both the history of the index that fund is following and how closely it has tracked that index. (I don't want to work that hard, so I just went with high-rated – keshlam Mar 2 at 23:11
... and note that I said market rate of return, not outperforming anything else; I don't care what anyone else is getting, I just want at least 8% with a risk level I consider acceptable. I'm getting more like 10% longterm average., straight thru dot-bomb and housing and other general setbacks, for near zero effort on my part. Plenty good enough for me. You can do better with more work or more risk or both, but I'm content to ride the elevator. – keshlam Mar 2 at 23:17

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