You will be able to explain what an index is and how an ETF holds the shares in it.
Every evening the news reads out a few numbers: the STI was up, the S&P 500 was down, the Nikkei closed flat. Most people hear them the way they hear the weather. Nadia did too, until she realised the fund she was about to buy was one of those numbers, turned into something she could own.
For most investors, that's what an ETF is, so the place to begin is the number it follows.
An index is a list of companies chosen by a fixed set of rules, with a value that's worked out from their share prices. The rules decide which companies get in, which drop out, and how much each one counts.
Take the Straits Times Index, the STI. Its rules pick 30 large companies listed on SGX, chosen mainly by size, with checks on how much of each company's shares are available to trade. When a company shrinks and another grows past it, the list changes at the next review. Nobody decides that one company deserves to be in because it has a good story. The rules decide.
Other indexes use different rules for different markets. The S&P 500 tracks large companies in the US. World indexes take in large and mid-sized companies across many countries at once, and narrower ones stick to a single sector or theme. The index provider publishes the rules and the current list, usually on its website, along with a factsheet.
An exchange-traded fund 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. The fund's job is to follow the index as closely as possible, minus its costs.
Some ETFs buy every company in the index. Others, when the index has thousands of companies, buy a large sample chosen to behave the same way. A few use contracts with banks, called swaps, to deliver the index's return instead of holding the shares. For a first fund, the factsheet tells you which approach a fund uses, and lesson 4.3, What can go wrong with an ETF, covers why it matters.
When the index changes its list, the fund changes its holdings to match. You don't have to do anything. The fund does the buying and selling for you.
The usual approach, used by the ETFs that follow these indexes too, is to give each company a weight based on its size, measured by the total value of its shares. A company worth twice as much as another counts twice as much in the index.
Here's a made-up index of three companies to show how that works. Company A is worth S$600 million, B is worth S$300 million and C is worth S$100 million. The total is S$1 billion, so A makes up 60% of the index, B 30% and C 10%. If you put S$1,000 into a fund tracking it, about S$600 goes into A, S$300 into B and S$100 into C.
In real indexes the effect is the same, only spread across more names. 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. That matters for risk, and lesson 4.3 comes back to it. For now, notice that when you buy an index fund you own a lot of the giants and a little of everything else.
Weighting by size also means the fund adjusts itself. A company whose shares rise becomes a bigger part of the index without the fund having to trade, while one that shrinks slowly fades from view.
A fund that picks shares based on a manager's judgement has to pay for that judgement: analysts, research and frequent trading. Those costs come out of the fund every year.
An index fund follows published rules. It needs people to run it carefully, but it doesn't need a team trying to outguess the market. It also trades less, since it only changes holdings when the index changes. So its yearly costs are usually low. That's one of the main reasons index ETFs suit a first investment. Unit trusts, robo-advisors and managed money compared looks at how active funds stack up against index funds in lesson 6.1, Why active funds as a group trail the market after costs.
Nadia now knew what she'd be buying: one slice of a list of companies, chosen by rules she could read, weighted by size, at a low yearly cost. The next step was to look at a real index. 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.
Pick one well-known index and write down how many companies it holds, what market it covers and its largest holding.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).