Explain what an index is and how an ETF holds the shares in it.
The evening news often reports how the STI, the S&P 500 and the Nikkei moved that day. Most people treat these numbers like a weather report. If you are about to buy your first fund, they are worth understanding, because for most investors an ETF is one of those index numbers turned into something they can own.
Nadia, an investor about to buy a fund, was like most people. She had heard the index numbers on the evening news without paying them much attention. When she looked closely at the fund she was about to buy, she realised it was one of those numbers, turned into something she could own.
An index is a list of companies chosen by a fixed set of rules. Its value is calculated from those companies' share prices. The rules decide which companies join the list, which drop out and how much each one counts.
The Straits Times Index, or STI, is a good one to start with. Its rules pick 30 large companies listed on SGX. They are chosen mainly by size, and the rules also check how many of each company's shares are available to trade. No company is added because it has a good story, since only the rules decide. When one company shrinks and another grows past it, the STI list changes at the next review.
Different indexes use different rules for different markets. The S&P 500 tracks large US companies. World indexes cover large and mid-sized companies across many countries at once. Narrower indexes cover a single sector or theme. The index provider publishes the rules and the current list, usually on its website, along with a factsheet.
An ETF that tracks an index buys the shares on the index's list in the same proportions. As the index's companies rise or fall in value, the fund's holdings move with them, and so does the value of each unit you own. The fund's job is to follow the index as closely as possible, minus its costs.
Funds do this in one of three ways. Some ETFs buy every company in the index. When an index has thousands of companies, some ETFs buy a large sample chosen to behave the same way as the full index. A few ETFs use swaps, which are contracts with banks, to deliver the index's return without holding the shares. The fund's factsheet shows which approach it uses, and Lesson 4.3, "What can go wrong with an ETF", explains why the approach matters.
When the index changes its list, the fund changes its holdings to match. You do nothing, because the fund does the buying and selling.
Most indexes, and the ETFs that follow them, use size weighting. Each company is weighted by its size, and size here means the total value of the company's shares. A company worth twice as much as another counts twice as much in the index.
To see how the weights are set, take a made-up index of three companies. These figures are invented for the example: Company A is worth S$600 million, Company B S$300 million and Company C S$100 million. The method has four parts:
Take the total value of each company's shares: S$600 million, S$300 million and S$100 million. Add these to get the index total, which is S$1 billion. Divide each company's value by the total to get its weight. A is 60%, B is 30% and C is 10%. Split any money put into a tracking fund across the companies by those weights. If you invest S$1,000, about S$600 goes into A, S$300 into B and S$100 into C.
Real indexes work the same way with many more companies. The largest companies take up a big share of the fund and the smallest barely register. In some indexes, the top ten companies make up a large slice of the total. This matters for risk, and lesson 4.3 returns to it. Buying an index fund means owning a lot of the largest companies and a little of everything else.
Size weighting also adjusts itself. A company whose shares rise becomes a bigger part of the index without the fund trading, and a company that shrinks slowly fades from view.
A fund that picks shares on a manager's judgement pays for that judgement through analysts, research and frequent trading. These costs come out of the fund every year. An index fund follows published rules. It still needs people to run it carefully, but it does not need a team trying to outguess the market. It also trades less, because it only changes holdings when the index changes.
As a result, an index fund's yearly costs are usually low. This is one of the main reasons index ETFs suit a first investment. Lesson 6.1, "Why active funds as a group trail the market after costs", in the course "Unit trusts, robo-advisors and managed money compared", compares active funds with index funds.
By now Nadia understood what she would be buying: one slice of a list of companies, chosen by rules she could read, weighted by size, at a low yearly cost. Her next step was to look at a real index, and it is yours too. Choose one you've heard of, find its page on the index provider's website, and look for how many companies it holds, which market it covers and which company is the largest.
Choose one well-known index. Write down how many companies it holds, which market it covers and what its largest holding is.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).