You hear it everywhere: "Just buy an ." But what is an index? What does the fund do with your money? And when you click "buy", what do you actually own? This lesson answers those three questions in plain words, so you know what you are holding before you hold it.
Before we start: what do you think?
You put €1,000 into a fund that follows an index of 500 large companies. What do you own?
✗ The fund buys and holds the shares, not you, so your name is not on them.
✓ Right: you own a slice of the fund, and the fund holds the companies for all its investors.
✗ That describes a CFD, which is a different product with no ownership.
✗ Your money is not lent to the fund company; it buys units of the fund itself.
What an index is
A is a list of investments plus a rule for how to measure them together. For example, "the 500 largest companies in a country" is a list. The rule says how much each company counts. The index then gives one number that moves when those companies, together, rise or fall.
An index is only a measurement, like a thermometer. You cannot buy a thermometer's reading. You can only buy something that copies it.
Most stock indexes weight each company by its size. The size of a company on the market is its : the share price times the number of shares. Bigger companies count for more.
Worked example: A tiny index of three companies
Imagine an index with only three companies:
| Company | Market capitalisation | Weight in the index |
|---|---|---|
| A | €600 billion | 60% |
| B | €300 billion | 30% |
| C | €100 billion | 10% |
| Total | €1,000 billion | 100% |
A fund that follows this index puts €600 of every €1,000 into A, €300 into B and €100 into C.
Now company A rises 20%, while B and C do not move. A is now worth €720 billion, and the total is €1,120 billion. The index has risen 12%. A's weight grows to about 64.3%, without the fund buying anything. Big winners get bigger in the index on their own.
That last detail matters. In a size-weighted index, a few very large companies can make up a big part of the whole. "500 companies" does not always mean 500 equal pieces.
Quick check
In a size-weighted index, why does a rising company's weight grow on its own?
Index fund and ETF: two ways to copy an index
An index fund collects money from many investors and buys the investments in the index, in the same weights. It does not try to pick winners. It only tries to match the index, minus its costs. Because it does not pay a team to choose investments, it is usually cheaper than a fund that does.
An ETF () is a fund whose units trade on a , like a company's shares. Many ETFs follow an index, but not all. Some follow a narrow theme, use , or are actively managed, so read what a fund does before you buy it.
The main practical differences:
| Traditional index fund | Index ETF | |
|---|---|---|
| How you buy | From the fund, at one price per day | On an exchange, during trading hours |
| Price you pay | The value calculated at the end of the day | The market price at that moment, plus a small |
| Where you hold it | Often directly with the fund or a bank | In an with a or bank |
For a long-term investor, both can do the same job. What matters more is what the fund holds and what it costs.
Long-running studies have found that most funds which try to beat their index fall behind it over ten years or more, mainly because of their higher costs. That is one reason many beginners start with index funds. It is not a promise that an index fund will do well. If the index falls 30%, the fund falls about 30% too. It is doing its job.
Quick check
If the index a fund follows falls 30%, what should you expect from the fund?
What you actually own
When you buy an index fund or ETF, you own units of the fund. The fund owns the companies (or ) for all its investors together. If the fund holds 500 companies, each of your units is a tiny slice of all 500.
A few details are worth checking in the fund's documents:
- How it copies the index. Some funds buy the actual shares. Others use contracts with a bank to deliver the index return. That second method adds the risk that the other side fails to pay.
- What it does with dividends. An "accumulating" fund reinvests them for you. A "distributing" fund pays them out to your account. Tax treatment can differ by country.
- The yearly fee. It is called the or ongoing charge, and it is taken from the fund every year. At 0.2%, that is €2 a year for every €1,000. (See Fees: the silent cost.)
- The currency. A fund that holds US companies can fall in euros when the dollar falls, even if the companies did not move.
You do not own the fund company, and the fund is not a . There is no fixed interest and no guarantee that you get your money back. You own a slice of whatever the fund holds, worth whatever the market says it is worth today.
Quick check
Name two things to check in a fund's documents before you buy.
This is education, not advice. Check your own situation, and the taxes in your country, before you invest.
Key takeaways
- An index is a list of investments plus a rule for weighting them. It is a measurement, not something you can buy.
- An index fund copies an index and does not try to pick winners. An ETF is a fund that trades on an exchange.
- Most indexes weight companies by size, so a few large companies can make up a big part of the index.
- You own units of the fund. The fund owns the investments for all its investors.
- Check how the fund copies the index, what it does with , its yearly fee and its currency.
Try this
Find the official document of any index fund or ETF (you do not need to buy anything). Write down four things: the index it follows, the number of holdings, the yearly fee in %, and its currency. Then calculate the fee in euros on €1,000.