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I have read that index funds are 'passively managed', but I am not entirely clear on how they actually work. Could someone please enlighten me?

Let's assume I would like to invest in the popular Vanguard 500 S&P Index. If I put in $1000 today, that amount gets distributed among the 500 companies based on their index percentage (right?) and if I invest into it $5000 after couple of months, its going to be a similar procedure I think.

Question: Since stocks in companies can go up or down, who manages to make sure that my account is not severely affected by this? An example:

Let's say out of the $1000 investment, 25%($250) are invested in company A. Now company A has been doing ok for couple of weeks, but then due to some factors in that company its stock has been tanking heavily and doesn't appear to have a chance to recover. In this kind of scenario, what does happen? Am I responsible of moving my money from the index fund to a different fund entirely or do the managers of index funds do something about it? Basically I am not clear on what 'passively managed' is I think.

  • You mean index fund specifically, and not ETF, right? – Joe Aug 26 '16 at 20:17
  • Yes, I mean index funds specifically (example: Vanguard S&P 500 Index fund). – Kiran Challa Aug 26 '16 at 20:25
  • As an aside, part of the theory behind investing in something like than S&P 500 is that it is rather rare for one of the 500 largest companies in the US to have its stock tank heavily without a chance of recovering, at least on a short timescale. On a longer timescale companies do fade and die, but as quid noted they can be removed from the index in that case. – BrenBarn Aug 27 '16 at 7:11
  • This article may provide some insight. Certainly an interesting read even if it doesn't fully answer your question. – Craig W Aug 29 '16 at 12:54
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Now company A has been doing ok for couple of weeks, but then due to some factors in that company its stock has been tanking heavily and doesn't appear to have a chance to recover. In this kind of scenario, what does happen?

In this scenario, if that company is included in the index being tracked, you will continue holding until such time that the index is no longer including that company.

Index funds are passively managed because they simply hold the securities contained in the index and seek to keep the allocations of the fund in line with the proportions of the index being tracked. In an actively managed fund the fund manager would try to hedge losses and make stock/security picks. If the manager thought a particular company had bad news coming maybe they would offload some or all the position. In an index fund, the fund follows the index on good days and bad and the managers job is to match the asset allocations of the index, not to pick stocks.

  • Thanks for taking time to answer my question. I didn't know that companies could be taken out of an index. Does this happen quite often? – Kiran Challa Aug 26 '16 at 20:27
  • @KiranChalla, I don't know if I'd call it frequent. In the case of the S&P 500 it's probably couple of times a year that companies will be replaced with others. An index like the Dow Jones Industrials is significantly less frequent; it was a pretty big deal when Apple replaced AT&T. – quid Aug 26 '16 at 20:36
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    @KiranChalla It happens however frequently is necessary to satisfy the definition of the index. So, if the S&P500 claims to index the 500 largest public companies by market cap, as soon as #500 drops below #501, then the old #500 would have to be dropped and the new #500 would have to be added. In reality, S&P does not follow that definition so rigorously, but it does change fairly often. – dg99 Aug 26 '16 at 20:57

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