Index funds part 2: What are index funds?

This post is the second in a series of four in which I cover all you need to know about one of the greatest inventions in finance – index funds. See also:

• Index funds part 1: What is a stock market index?
• Index funds part 3: Why invest in index funds?
• Index funds part 4: How to invest in index funds

Having been introduced to stock market indices in the previous article, we can now move on to discuss the main topic in this series: what exactly are index funds?

What is an index fund?

An index fund is an investment product that is designed to track a specific stock market index. Index funds can be mutual funds or exchange traded funds (ETFs). I only use the latter, and we will use the term ‘index fund’ to refer only to index ETFs.

Exchange-traded funds, or ETFs, are investment funds that are traded on stock exchanges. Therefore, shares of an ETF can be bought and sold just like shares of individual companies. ETFs hold assets, such as stocks or bonds. When you buy a share of an ETF, you are indirectly buying a small part of the assets that the ETF holds.

An index ETF (the main topic of this article) is an ETF which holds the stocks constituting a selected index in the proportion in which they constitute that index. In this way, the value of the ETF (arising from the underlying stocks) mirrors the performance of that selected stock market index.

Let us go back to our earlier example. Suppose that on 2 Jan 2021, The ABCDEF Index (TAI) comprises 62.5% ABC shares and 37.5% DEF shares, and has a value of 120. We can then create an ETF that tracks this index. We will call this the Squirrel TAI ETF. The Squirrel TAI ETF will then trade on the stock exchange. Suppose that you buy a Squirrel TAI ETF share for $10. This means that you indirectly own $6.25 worth of ABC shares and $3.75 worth of DEF shares. If the value of TAI increases by 10% from 120 on 2 Jan 2021 to $132 on 3 Jan 2021, the value of Squirrel TAI ETF shares will rise by 10% from $10 to $11 on 3 Jan 2021. (If it did not, then market players could profit from arbitrage, which would bring the price of the ETF shares in line with the value of the underlying index.)

Examples

Some actual index ETFs (which I invest in) include:

Index ETF	Manager	Stock exchange / currency	Index it tracks	Fees
SPDR S&P 500 ETF Trust (SPY)	State Street Global Advisors	NYSE / USD	S&P 500	0.0945% per annum
Vanguard FTSE 100 UCITS ETF GBP (VUKE)	Vanguard	LSE / GBP	FTSE 100 Index	0.09% per annum
Nikko AM Singapore STI ETF (G3B)	Nikko Asset Management	SGX / SGD	Straits Times Index	0.30% per annum

The last column gives the amount of fees that the company charges to manage the ETF. The fees tend to be very low (especially for SPY and VUKE) because index ETFs are passively managed, which means to say that the manager does not need to do any research on individual companies; they simply mirror the index passively. Clearly, the lower the fees, the better, as more of your investment is used to buy stocks in the index (as opposed to making the company that manages the ETF rich).

What about dividends?

Companies usually pay dividends, which are (relatively small) payments that the company makes to its shareholders. The money used to make dividend payments usually comes from the profit that the company made in the period leading up to the payment. In Singapore, most companies pay dividends once or twice a year, although there are companies that pay dividends three or four times a year.

Suppose that the Amazing Biscuit Company (ABC) makes a profit (that is, revenue is greater than costs) consistently, and uses some of that profit to pay a dividend to shareholders. Suppose that ABC pays out $0.02 per share in January 2020 and $0.01 per share in July 2020. This is a total dividend of $0.03 (per share) for the year of 2020 paid to shareholders.

ABC	Dividend amount	Percentage yield (based on share price of $1.00)
January 2020	$0.02	2.0%
July 2020	$0.01	1.0%
2020 overall	$0.03	3.0%

Assuming that shares in ABC trade at about $1.00 throughout 2020, we can calculate the dividend yield, which is defined as dividend amount (per share) relative to share price. The 2020 dividend yield of ABC is therefore 3.0% (computed as $0.03 divided by $1.00). This means that if you had invested $10,000 in ABC before 2020, by the end of 2020, you would have received $300 in cash as dividends.

We have seen that index ETFs buy shares in the companies that constitute the index being tracked, so what happens when these companies pay out dividends to their shareholders (including the ETF)? Remember that the companies managing ETFs charge fees? They usually deduct their fees from the dividends being paid (this prevents the fees from eroding the holdings of shares in the constituent companies), and then pay out the rest as dividends to the shareholders of the ETF. That is, the constituent companies pay the ETF dividends, and the ETF then uses those dividends to pay its own shareholders dividends.

What determines the dividend yield of an index ETF? Just as the share price of an ETF is determined by the weighted average of the share prices of the constituent companies, the dividend yield of an index ETF is determined by the weighted average dividend yields of the constituent companies.

Take a look at the dividend yields of the three examples of index ETFs introduced above:

Index ETF	Manger	Index it tracks	Distribution frequency	Dividend yield
SPDR S&P 500 ETF Trust (SPY)	State Street Global Advisors	S&P 500	Quarterly	1.33% (as of 30 Apr 2021)
Vanguard FTSE 100 UCITS ETF GBP (VUKE)	Vanguard	FTSE 100 Index	Quarterly	2.76% (as of 31 Mar 2021)
Nikko AM Singapore STI ETF (G3B)	Nikko Asset Management	Straits Times Index	Semi-annually	3.71% (as of 30 Apr 2021)

To sum up

• An index ETF is an investment fund that invests in the stocks constituting a particular index.
• You can buy and sell shares in an ETF just as you would shares in individual companies.
• When you buy a share of an index ETF, you are indirectly buying small parts of all the companies that the index comprises.
• Dividends paid by the companies that make up the index are paid out to the shareholders of the index ETF.

Take a look at the next article in this series to see why I think index funds are a wonderful invention for cash-strapped young adults.