What an index fund actually holds

An index fund is a pooled investment that aims to match the performance of a published benchmark rather than beat it. The manager does not pick stocks; the index provider's rules do. That makes the fund cheap to run, but it also means that what you own is determined entirely by how the index is constructed.

How the benchmark is built

Most broad equity indices are weighted by market capitalisation: each company's weight equals its market value divided by the total market value of all constituents. A company worth ten times as much as another gets ten times the weight. The practical consequence is concentration. In many large-cap indices, the ten biggest companies account for a quarter to a third of the total, and the smallest hundred together may account for less than the largest one.

Providers usually adjust for free float, counting only shares that are available to trade rather than those held by founders, governments or other locked-in holders. They also apply eligibility rules on listing venue, liquidity and minimum size, and they review membership on a schedule, typically quarterly or semi-annually.

Not all indices use market-cap weighting. Equal-weight versions give every constituent the same share, which increases exposure to smaller companies and requires more frequent rebalancing. Some bond indices weight by the amount of debt outstanding, which means the most indebted issuers get the largest weights, a feature investors should be aware of.

How the fund tracks it

A fund can hold every constituent in index proportions, known as full replication. For a large index with thousands of members, that is expensive, so some funds hold a representative sample chosen to match the index's characteristics. Others use derivatives, such as swaps with a bank, to deliver the index return without holding the underlying securities, which introduces counterparty risk.

Whichever method is used, the fund will not match the index exactly. The gap is the tracking difference, and it reflects the management fee, trading costs, the treatment of dividends and withholding tax, and any income from lending securities to other investors. A fund with a low headline fee but poor execution can lag its index by more than one with a slightly higher fee, so the tracking difference over several years is the better measure of cost.

What rebalancing does

When the index changes, the fund must trade to follow it. Companies entering an index tend to see their shares rise in the days before inclusion, as funds buy; companies leaving tend to see the opposite. Index funds therefore buy after a stock has risen and sell after it has fallen, a small structural drag that active traders sometimes exploit.

Rebalancing also matters within the index. As a company grows in value, its weight increases automatically, so a market-cap fund never trims a winner. That keeps turnover low but means that the fund's concentration rises during periods when a handful of stocks lead the market.

What you actually own

Buying a broad market index fund gives you a diversified but not evenly spread holding: heavy in the largest companies and sectors, light in everything else. It also gives you exposure to whichever currency the constituents earn in, which for a global fund means a large dollar component. Some funds hedge that currency exposure; most do not.

Bond index funds add their own considerations, including the average duration of the holdings and the split between government and corporate debt. Reading the fund's factsheet and the index methodology document takes a few minutes and answers most of these questions.

This guide is general information, not investment advice.