How does an index fund work?

Index funds, like those run by us at Kernel, are dramatically disrupting traditional active fund managers and empowering a new generation of investors. But how do they actually operate?

Index in a minute

Before we explain how an index fund works, we better quickly cover what an index is.

Financial markets around the world are tracked by millions of indices every day. These indices are calculated by one of a handful of global companies, such as S&P Dow Jones Indices (S&P DJI). The indices that they calculate are designed to reflect the collective performance of the companies in the market, or a part of the market. For example, New Zealand has the S&P/NZX 20 index, Australia has the S&P/ASX 200, and the United States has the S&P 500.

When an index is launched a starting value is set by the index provider. This can be any number, but let’s say 1,000. At the end of the day, the index provider calculates the collective performance of the companies in the index. Some may be up, and some may be down. 

The S&P/NZX 20 Index is designed to measure the performance of the 20 largest companies listed on the NZX (NZ Stock Exchange). Let’s assume that as a group, the performance of the 20 companies combined for the day was 1%. The index value at the end of the first day will be calculated and will increase by 1% to 1,010.

Each day the index value is calculated and you can graph these daily values over different time periods to see how the market performed (just google one of the indices above for a live example). In fact, thanks to advancements in technology, indices are now calculated in real time throughout the day while the market is open.

How does an index fund operate?

The role of an index fund manager is to ensure that their index fund matches the performance of the respective index it is tracking.

In the case of Kernel, we have an NZ 20 fund, and our job is to ensure that the fund matches, as close as possible, the composition, and therefore performance, of the S&P/NZX 20 index. As an investor in this fund, with a single investment you get the benefit of being diversified across 20 companies and can expect to receive the collective return of those companies over time (the index return), less the management fee of the fund and any tax.

To track the index, the manager invests in all of the companies in the same proportion as they are represented in the index. Looking at the S&P/NZX 20 index the weightings of the 20 companies in the index, as at 31 Dec 2019 is:

Company% at 31 Dec 2019
Fisher & Paykel Healthcare13.63%
The a2 Milk Co11.81%
Auckland Intl Airport8.86%
Spark8.50%
Ryman Healthcare7.25%
Meridian Energy6.71%
Contact Energy5.47%
Fletcher Building4.52%
Mainfreight3.84%
Infratil3.55%
Mercury NZ3.38%
EBOS Group3.03%
Chorus2.93%
SkyCity Entertainment2.84%
Port of Tauranga2.66%
Goodman Property2.63%
Kiwi Property Group2.62%
Precinct Properties2.11%
Z Energy1.88%
Air New Zealand1.69%

Therefore, if you had $10,000 invested in the NZ 20 index fund on the 31st December, you can expect that you would have had approximately $1,363 in Fisher & Paykel shares (noting the 13.63% above).

In fact, this is one of the great benefits of index funds – transparency. At any time you can go onto the fund managers website and see exactly what companies the fund is invested in and how big they are in the fund.

How often does an index fund trade?

One of the reasons index funds have become so successful is their low fees. Index fund managers don’t need to pay expensive analysts to research companies and they also don’t need to trade very often. This keeps the costs (which ultimately eat into your returns as the investor) down!

One of the misconceptions about index funds, even by professional investors, is that they trade every day to ensure their investments continue to match the index.

Looking at the list of the 20 companies in the S&P/NZX 20 index, on the 31st December, Spark’s weighting in the index was 8.50%. The next day this weighting will be different, because throughout the day Spark may have increased or decreased in value, and so will the other 19 companies in the index.

However, that does not mean that the index fund needs to trade to match the new weighting.

Here’s a simple example to help explain why:

Let’s imagine there is a new index and it only has two companies in it, Company A and Company B. Both of these companies have 100 shares on issue, and each share is currently worth $1. That means that each company is worth $100 ($1 per share X 100 shares). On the first day, because each company has the same value ($100), the weighting of each company within the index is 50%.

Let’s assume an index fund is launched that tracks the imaginary index and the fund has $10 invested. On day one, the fund manager needs to invest this money to match the index, therefore they buy 5 shares at $1 each in Company A and 5 shares at $1 each in Company B. The fund now has $5 invested in each company, and the weighting is 50% each, perfectly matching the index.

On day 2, Company B announces that they’ve made record sales and their shares increase in value from $1 to $2. All of a sudden Company B is worth $200, while Company A has had no news and is still worth $100.

What’s happened to the index?

As Company B is worth $200, it’s weighting in the index has grown from 50% to 67% ($200/$300), while Company A has fallen from 50% to 33%.

What does the index fund need to do?

Nothing!

Remember, the index fund has already invested their $10 and has 5 shares in each company. The value of the 5 shares in Company B has gone from $5 to $10 and the value of the 5 shares in Company A remains at $5. Therefore, the value of the index fund is now $15 and the weighting of Company B in the index fund automatically matches the weighting in the index ($10/$15 = 67%).

As the index fund doesn’t need to constantly trade to match the index, it keeps costs low.

There is one other time that the index fund needs to trade – it’s referred to as a “rebalance”.

Rebalancing

This happens when the index provider rebalances the index. Most indices typically have a semi-annual or quarterly index rebalance. The rebalance checks whether the current companies in the index still satisfy the index criteria. They also check whether a new company needs to be added into the index.

For example, if the company in position 20 in the S&P/NZX 20 index had fallen in value during the quarter, and a company sitting outside the index had grown in value, the company at the bottom of the index will be dropped and replaced by the company that has grown in value.  

The fund manager will adjust the fund accordingly – selling the shares in the company that was dropped and buying the new company in the correct weighting.  

And that folks, is how an index fund works. More questions? Get in touch!

You can read all the nitty gritty on our index funds here.


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