Index ETFs

What the fund is following 

An index is a rule book, not a portfolio. It states which securities qualify, how their weights are set, when the list is reviewed and what happens when a constituent is taken over or delisted. An index fund is the portfolio that results from applying that rule book with real money. The index provider publishes the rules and the constituent file; the fund licenses them and holds what they describe. That division is the reason index funds are described as passive: the discretion sits with the index provider, and the fund's job is to reproduce the outcome rather than to select anything.

The broad market funds most commonly quoted follow well known rule books. The SPDR S&P 500 ETF and the Vanguard S&P 500 ETF follow the same large capitalisation American index. The Invesco QQQ Trust follows an index of the largest non financial companies listed on the Nasdaq, which is why it is concentrated in technology without being a technology fund by construction. The SPDR Dow Jones ETF follows a price weighted index of long established American industrial and consumer names. The iShares Russell 2000 follows a small capitalisation index. The Vanguard Total Market fund follows an index covering the whole listed American market rather than a capitalisation band, and the Vanguard Developed Markets and iShares MSCI EAFE funds do the same job for developed markets outside the United States.

The weights come with the index 

Whatever the index does about weighting, the fund inherits. Most large equity indices weight constituents by free float market capitalisation, which means the value of the shares actually available to trade rather than the whole company, so a company's influence on the fund rises and falls with its market value automatically. A price weighted index instead gives each constituent a weight proportional to its share price, so a high priced share moves the index more than a larger company with a lower price. An equal weighted index resets every constituent to the same weight at each review, which requires the fund to sell what has risen and buy what has fallen at every rebalance.

That arithmetic is what people mean when they call a broad index fund concentrated. The fund holds hundreds of names and describes itself accurately as diversified by count, while a small group of the largest constituents produces the majority of the daily movement. Both statements are true at once, and the holdings file, which every issuer publishes, is where the actual proportion can be read.

Review dates, and why the fund trades on them 

Index providers publish a calendar of reviews. A regular rebalance resets weights to the rule book's specification. A reconstitution changes the membership, adding companies that now qualify and removing those that no longer do. Between reviews, a takeover, a delisting or a large share issue can force an unscheduled change. Every fund licensed to the index has to match the new file at the effective close, which concentrates a great deal of trading in the affected names into a single session, and is why index review dates are watched by participants who are not index funds at all.

Reviews also explain a category of question that arises when a fund's holdings appear to disagree with a published index. A constituent file is a snapshot with an effective date. A holdings file is a snapshot of the portfolio as it stood at a different moment. The two can differ for entirely ordinary reasons around a review without anything having gone wrong.

Why two funds on the same index are not identical 

Several funds may track one index and still post different returns, and the sources of the difference are known and small. The management fee accrues daily inside each portfolio, so a cheaper fund starts each year fractionally ahead. Replication method matters: a fund holding every constituent tracks differently from one holding a representative sample. Treatment of dividends matters, because cash received from constituents sits in the fund until it is reinvested or distributed, and that cash is not invested in the market while it waits. Securities lending revenue, where a fund lends holdings against collateral, works in the opposite direction. Tax on foreign income differs by the fund's domicile, which can be the largest source of divergence for a fund holding foreign shares.

Trading characteristics differ too, and separately from returns. A fund with a heavily traded order book generally shows a narrower bid offer spread than a smaller fund on the same index, which affects the cost of dealing in it rather than what it holds. The two funds can be economically near identical while being materially different to trade.

An index fund and a contract on the index itself 

Both instruments give exposure to the same market and they are not the same instrument. An index contract for difference references a calculated index level directly, and that level is a number published by the index provider rather than a security anyone can hold. A contract on an index fund references the price of a listed security whose supply is adjusted by creation and redemption and whose price can sit at a small premium or discount to the value of its holdings.

Three practical differences follow. Hours differ, because an index contract commonly quotes for far longer than the exchange session in which the fund's shares trade. Dividend handling differs: a price index level falls as constituents go ex dividend and brokers conventionally apply an adjustment to open index positions, while an equity fund receives the cash into its portfolio and distributes it later, so the fund's own price steps down on its distribution date instead. Contract size differs, since an index contract is written as a money amount per index point and a fund contract is written on a number of fund shares.