ETFs are among the most popular passive investment instruments, but their operation involves more than simply copying the market. Understanding how indices are constructed and how funds track them helps investors better understand what they are actually investing in.

What Is a Stock Market Index and What Is It Used For?

A stock market index is an indicator that tracks the performance of a specific group of securities and serves as a kind of market “benchmark.” It can follow an entire stock market, a particular region, sector, or selected group of companies. Well-known examples include the S&P 500, Nasdaq-100, and MSCI World. Indices also serve as benchmarks against which the performance of funds, portfolios, or investment strategies can be compared.

Who Decides Which Companies Are Included in an Index?

The composition of an index is not determined randomly but according to rules established by its provider, such as S&P Dow Jones Indices, MSCI, or FTSE Russell. When selecting companies, factors such as their size, liquidity, geographic or sector classification, or the proportion of shares available to investors may be considered. Two indices focused on a similar market therefore do not necessarily contain the same companies and may also differ in terms of risk and performance.

Not Every Company Has the Same Weight in an Index

A company’s importance within an index also depends on its weight. The most common approach is market-capitalisation weighting, where larger companies have a greater influence on the index’s overall performance. However, equally weighted, price-weighted, and fundamentally weighted indices also exist. For example, if one company represents 8% of an index while another accounts for only 0.5%, the same movement in their share prices will affect the index’s overall result very differently.

The Composition of an Index Changes Over Time

An index is not a fixed list of companies. Its provider regularly reviews whether companies continue to meet the required criteria and may add or remove them accordingly. Changes to index constituents are known as reconstitution, while rebalancing adjusts their respective weights. In this way, the index continuously adapts to changes in the importance of individual companies within the market.

How Can an Investor Invest in an Index?

Investors cannot buy an index itself because it is merely a calculated indicator. However, they can track its performance through an ETF, or exchange-traded fund, which aims to replicate the respective index as closely as possible. With a single purchase, an investor can therefore gain exposure to a large number of companies without having to buy each of them separately (if you are interested in how ETFs can be used to build a simple investment portfolio, you can read more in our previous article).

How Does an ETF Replicate Its Index?

With physical replication, an ETF directly owns the securities included in the index. It may purchase all of its constituents or use sampling, meaning that it holds only a representative portion of the portfolio. With synthetic replication, the performance of the index is achieved through derivative contracts. These approaches differ in terms of costs and risks, which means an ETF does not always have to physically own every share included in the index it tracks.

Why Does an ETF Not Track Its Index Perfectly?

An ETF’s performance may differ slightly from that of the index it tracks. This difference is known as the tracking difference and may be influenced by factors such as fees, transaction costs, taxes, dividends, or the replication method used. Tracking error, on the other hand, shows how much this deviation fluctuates over time. When comparing ETFs, investors should therefore look not only at the TER fee but also at how accurately the fund tracks its index in practice (you can read more about how even small fees can affect investment returns in our previous article).

The Same Market Label Does Not Mean the Same Investmentň

Two ETFs focused, for example, on global equities, the US market, or technology may track different indices and offer different portfolios. They may differ in the number of companies they include, their respective weights, geographic or sector exposure, as well as their selection rules. Before making a purchase, investors should therefore look not only at the ETF’s name but also at the exact index it tracks and its methodology. By buying a fund, an investor is also indirectly choosing the rules according to which their investment will be constructed.

For more investment trends and useful tips, take a look at our previous articles on AxilAcademy.