I have read the Wikipedia page but I still don't get the concept. Who maintains the "index of a specific financial market"?

For example, one index fund could invest in companies in the S&P 500, but

  1. who computes the S&P 500?
  2. Why are they sharing this information and
  3. how do they recuperate the costs inherent in computing the S&P 500?

Even if there are computer systems managing these indices, no computer system can be "trusted" as it's as good as the team of software programmers who implemented a set of rules that they are not in ownership of.

These rules change and might even be misunderstood between the owners ("business people") and the implementers (programmers).

Hence, by this understanding of mine, no index can be passive. I expect significant human interaction, i.e. "active management" to be involved in the maintenance of these indexes.

To complete this question:

  • Why is then "active management" not required for indexed funds?

  • and how does it lower taxes? (perhaps this could be a different question if this has become too broad)

  • Have you done much research into how stock indices are constructed and managed? Your claim of "active management" makes me question if you've researched this issue much along with how long some index funds have been around as there are some that have been around for decades. – JB King Aug 13 '13 at 18:07

who computes the S&P 500?

Standard and Poor's.

Why are they sharing this information and

Because that's what they do. This is a financial research company.

how do they recuperate the costs inherent in computing the S&P 500?

By charging clients for other information. The computing of the index itself is not all that complicated, its coming up with the index that's a problem. Once they've come up with the formula, and it became widely accepted, the computation itself is not an issue. But the fact that its so popular leads to the S&P brand recognition, and people come and pay good money for their other services (ratings and financial analysis of securities).

They do more work for free. For example, the ratings of various government debts are being done by S&P for free (governments don't pay for that), while private bonds are rated for a fee (corporations pay to have their bonds rated).

Also, as noted by JBKing, there are probably some licensing fees for using the index name in the fund name (and other users are probably paying the licensing fee, like the news agencies and the exchanges). S&P500 is a registered trademark, and as such cannot be used without the owner's permission.

Why is then "active management" not required for indexed funds

Because no research and stock picking is required. In fact, these funds don't really require a manager, they can be managed by a simple script.

and how does it lower taxes? (perhaps this could be a different question if this has become too broad)

Actively managed funds perform a lot more buy/sell operations, each leading to tax consequences to the fund (which rolls them over to the investors). Index funds only buy and sell to re-balance back to the index (or when the makeup of the index changes, usually once a year or half a year), leading to much lesser realized capital gains to the fund, thus much lesser tax consequences.

  • A fund all buys and sells when the makeup of the index changes. – mhoran_psprep Aug 13 '13 at 18:22
  • A lot of index funds have licensing agreements with the index makers in order to use the name of the index in the fund. This is generally a small fee as a percent of assets on the fund but there is a charge here worth noting. – JB King Aug 13 '13 at 18:27
  • A tiny bit of human effort when stocks are added or removed from index. Falling off index when merged/taken private/etc, and added to replace the guys that were removed. – JTP - Apologise to Monica Aug 13 '13 at 20:47
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    @Joe I can think of fairly simple to implement automation to do that. Some subscription fees to the data provider (S&P?) which the funds, I'm sure, are paying anyway, and some one-time $$$ to a software consultant like myself to implement. That's it. I'm sure it won't cost more than a day-worth of pay of an average wall-street fund manager. – littleadv Aug 13 '13 at 20:56
  • You got me. The intelligence is upstream, at S&P. The index 'manager' is just following that. – JTP - Apologise to Monica Aug 14 '13 at 1:05

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