What exactly do fund managers of index trackers do?
"From How are indexes weighted?: Market-capitalization weighted indexes (or market cap- or cap-weighted   indexes) weight their securities by market value as measured by   capitalization: that is, current security price * outstanding shares.   The vast majority of equity indexes today are cap-weighted, including   the S&P 500 and the FTSE 100. In a cap-weighted index, changes in the   market value of larger securities move the index’s overall trajectory   more than those of smaller ones. If the fund you are referencing is an ETF then there may be some work to do to figure out what underlying securities to use when handling Creation and Redemption units as an ETF will generally have shares created in 50,000 shares at a time through Authorized Participants. If the fund you are referencing is an open-end fund then there is still cash flows to manage in the fund as the fund has create and redeem shares in on a daily basis. Note in both cases that there can be updates to an index such as quarterly rebalancing of outstanding share counts, changes in members because of mergers, acquisitions or spin-offs and possibly a few other factors. How to Beat the Benchmark has a piece that may also be useful here for those indices with many members from 1998: As you can see, its TE is also persistently positive, but if anything   seems to be declining over time. In fact, the average net TE for the   whole period is +0.155% per month, or an astounding +1.88% pa net   after expenses. The fund expense ratio is 0.61% annually, for a   whopping before expense TE of +2.5% annually. This is once again   highly statistically significant, with p values of 0.015 after   expenses and 0.0022 before expenses. (The SD of the TE is higher for   DFSCX than for NAESX, lowering its degree of statistical   significance.) It is remarkable enough for any fund to beat its   benchmark by 2.5% annually over 17 years, but it is downright eerie to   see this done by an index fund. To complete the picture, since 1992 the Vanguard Extended Index Fund   has beaten its benchmark (the Wilshire 4500) by 0.56% per year after   expenses (0.81% net of expenses), and even the Vanguard Index Trust   500 has beaten its benchmark by a razor thin 0.08% annually before   (but not after) expenses in the same period. So what is going on here? A hint is found in DFA's 1996 Reference   Guide: The 9-10 Portfolio captures the return behavior of U.S. small company stocks as identified by Rolf Banz and other academic   researchers. Dimensional employs a ""patient buyer"" discount block   trading strategy which has resulted in negative total trading costs,   despite the poor liquidity of small company stocks. Beginning in 1982,   Ibbotson Associates of Chicago has used the 9-10 Portfolio results to   calculate the performance of small company stocks for their Stocks,   Bonds, Bills, and Inflation yearbook. A small cap index fund cannot possibly own all of the thousands of   stocks in its benchmark; instead it owns a ""representative sample.""   Further, these stocks are usually thinly traded, with wide bid/ask   spreads. In essence what the folks at DFA learned was that they could   tell the market makers in these stocks, ""Look old chaps, we don't have   to own your stock, and unless you let us inside your spread, we'll   pitch our tents elsewhere. Further, we're prepared to wait until a   motivated seller wishes to unload a large block."" In a sense, this   gives the fund the luxury of picking and choosing stocks at prices   more favorable than generally available. Hence, higher long term   returns. It appears that Vanguard did not tumble onto this until a   decade later, but tumble they did. To complete the picture, this strategy works best in the thinnest   markets, so the excess returns are greatest in the smallest stocks,   which is why the positive TE is greatest for the DFA 9-10 Fund, less   in the Vanguard Small Cap Fund, less still in the Vanguard Index   Extended Fund, and minuscule with the S&P500. There are some who say the biggest joke in the world of finance is the   idea of value added active management. If so, then the punch line   seems to be this: If you really want to beat the indexes, then you   gotta buy an index fund."
"They do but you're missing some calculations needed to gain an understanding. Intro To Stock Index Weighting Methods notes in part: Market cap is the most common weighting method used by an index.   Market cap or market capitalization is the standard way to measure the   size of the company. You might have heard of large, mid, or small cap   stocks? Large cap stocks carry a higher weighting in this index. And   most of the major indices, like the S&P 500, use the market cap   weighting method. Stocks are weighted by the proportion of their market cap to the total   market cap of all the stocks in the index. As a stock’s price and   market cap rises, it gains a bigger weighting in the index. In turn   the opposite, lower stock price and market cap, pushes its weighting   down in the index.  Pros Proponents argue that large companies have a bigger effect on the   economy and are more widely owned. So they should have a bigger   representation when measuring the performance of the market. Which is   true. Cons It doesn’t make sense as an investment strategy. According to a market   cap weighted index, investors would buy more of a stock as its price   rises and sell the stock as the price falls. This is the exact   opposite of the buy low, sell high mentality investors should use. Eventually, you would have more money in overpriced stocks and less in   underpriced stocks. Yet most index funds follow this weighting method. Thus, there was likely a point in time where the S & P 500's initial sum was equated to a specific value though this is the part you may be missing here. Also, how do you handle when constituents change over time? For example, suppose in the S & P 500 that a $100,000,000 company is taken out and replaced with a $10,000,000,000 company that shouldn't suddenly make the index jump by a bunch of points because the underlying security was swapped or would you be cool with there being jumps when companies change or shares outstanding are rebalanced? Consider carefully how you answer that question. In terms of histories, Dow Jones Industrial Average and S & P 500 Index would be covered on Wikipedia where from the latter link: The ""Composite Index"",[13] as the S&P 500 was first called when it   introduced its first stock index in 1923, began tracking a small   number of stocks. Three years later in 1926, the Composite Index   expanded to 90 stocks and then in 1957 it expanded to its current   500.[13] Standard & Poor's, a company that doles out financial information and analysis, was founded in 1860 by Henry Varnum Poor. In   1941 Poor's Publishing (Henry Varnum Poor's original company) merged   with Standard Statistics (founded in 1906 as the Standard Statistics   Bureau) and therein assumed the name Standard and Poor's Corporation.   The S&P 500 index in its present form began on March 4, 1957.   Technology has allowed the index to be calculated and disseminated in   real time. The S&P 500 is widely used as a measure of the general   level of stock prices, as it includes both growth stocks and value   stocks. In September 1962, Ultronic Systems Corp. entered into an agreement   with Standard and Poor's. Under the terms of this agreement, Ultronics   computed the S&P 500 Stock Composite Index, the 425 Stock Industrial   Index, the 50 Stock Utility Index, and the 25 Stock Rail Index.   Throughout the market day these statistics were furnished to Standard   & Poor's. In addition, Ultronics also computed and reported the 94 S&P   sub-indexes.[14] There are also articles like Business Insider that have this graphic that may be interesting: S & P changes over the years The makeup of the S&P 500 is constantly changing notes in part: ""In most years 25 to 30 stocks in the S&P 500 are replaced,"" said   David Blitzer, S&P's Chairman of the Index Committee. And while there   are strict guidelines for what companies are added, the final decision   and timing of that decision depends on what's going through the heads   of a handful of people employed by Dow Jones." Disclosure - I love Jack Bogle. Jack basically invented the index fund, and as a result, let the common investor have an opportunity to choose a long term return of (S&P-.05%) instead of losing nearly 2% that many funds in that day charged. The use of index investing has saved investors many billions of dollars.  The 1% round trip, total cost to buy/sell, was common. Fees for trading have since dropped. I happen to use Schwab who charges $9 for a trade. On $100,000, this is not .5% ($500) but less than .01%. I think it's safe to say that billion dollar mutual funds are paying even less for trades that I do. I believe Jack's example here is a combination of old data and hyperbole.  The cost is not so much for the trades, per se, but for the people managing the fund. An index fund has a manager of course, but it's pretty much run by a computer. "I actually love this question, and have hashed this out with a friend of mine where my premise was that at some volume of money it must be advantageous to simply track the index yourself. There some obvious touch-points: Most people don't have anywhere near the volume of money required for even a $5 commission outweigh the large index fund expense ratios. There are logistical issues that are massively reduced by holding a fund when it comes to winding down your investment(s) as you get near retirement age. Index funds are not touted as categorically ""the best"" investment, they are being touted as the best place for the average person to invest. There is still a management component to an index like the S&P500.  The index doesn't simply buy a share of Apple and watch it over time.  The S&P 500 isn't simply a single share of each of the 500 larges US companies it's market cap weighted with frequent rebalancing and constituent changes.  VOO makes a lot of trades every day to track the S&P index, ""passive index investing"" is almost an oxymoron. The most obvious part of this is that if index funds were ""the best"" way to invest money Berkshire Hathaway would be 100% invested in VOO.  The argument for ""passive index investing"" is simplified for public consumption.  The reality is that over time large actively managed funds have under-performed the large index funds net of fees.  In part, the thrust of the advice is that the average person is, or should be, more concerned with their own endeavors than they are managing their savings.  Investment professionals generally want to avoid ""How come I my money only returned 4% when the market index returned 7%?  If you track the index, you won't do worse than the index; this helps people sleep better at night. In my opinion the dirty little secret of index funds is that they are able to charge so much less because they spend $0 making investment decisions and $0 on researching the quality of the securities they hold.  They simply track an index; XYZ company is 0.07% of the index, then the fund carries 0.07% of XYZ even if the manager thinks something shady is going on there. The argument for a majority of your funds residing in Mutual Funds/ETFs is simple, When you're of retirement age do you really want to make decisions like should I sell a share of Amazon or a share of Exxon?  Wouldn't you rather just sell 2 units of SRQ Index fund and completely maintain your investment diversification and not pay commission?  For this simplicity you give up three basis points?  It seems pretty reasonable to me." "Index funds do leech a ""free ride"" on the coattails of active traders.  Consider what would happen if literally everyone bought index funds.  For a company there would be no motivation to excel. Get listed; all the index funds are forced to buy your stock; now sit on your derriere playing Freecell, or otherwise scam/loot the company.  Go bankrupt. Rinse wash repeat.  This ""who cares who John Galt is"" philosophy would kill the economy dead.   Somebody has to actually buy stocks based on research, analysis and value.  Company managers need to actively fear, respect and court those people.  They don't need to be mutual-fund managers, but they do need to be somebody.  Maybe activist investors like Warren Buffett will suffice.  Maybe retirement fund or endowment managers like CalPERS or Harvard can do this.  Better be somebody!  I'm all for index funds... Just saying only a fraction of the market's capital can be in index funds before it starts into a tragedy of the commons." The Financial Services Compensation Scheme says: Investments   FSCS provides protection if an authorised investment firm is unable to pay claims against it. For example: for loss arising from bad investment advice, poor investment management or misrepresentation; when an authorised investment firm goes out of business and cannot return investments or money. Investments covered include: stocks and shares; unit trusts; futures and options; personal pension plans and long-term investments such as mortgage endowments. An index-tracking fund provided by an authorised investment firm would seem to qualify in the cases where: The critical points here then are: I can't find anything easily to hand about FSCS on Blackrock's website, so I would imagine that you'd need to consult the documentation on your investment product to be sure. index ETF tracks indented index (if fund manager spend all money on Premium Pokemon Trading Cards someone must cover resulting losses) Most Index ETF are passively managed. ie a computer algorithm would do automatic trades. The role of fund manager is limited. There are controls adopted by the institution that generally do allow such wide deviations, it would quickly be flagged and reported. Most financial institutions have keyman fraud insurance. fees are not higher that specified in prospectus Most countries have regulation where fees need to be reported and cannot exceed the guideline specified. at least theoretically possible to end with ETF shares that for weeks cannot be sold Yes some ETF's can be illiquid at difficult to sell. Hence its important to invest in ETF that are very liquid. There are many technical answers above , but the short story to me is that very few active fund managers consistently beat the market. Look at the results of actively managed funds. Depending on whose analysis you read, you will find out that somewhere between 80-90% of fund managers in a given year do not beat passive index funds. So go figure how you will do compared to a mutual fund manager who has way more experience than you likely have. So, that in itself is moderately interesting, but if you look at same-manager performance over several consecutive years it is rare to find anyone that goes beats the market for more than a few years in a row. There are exceptions, but go pick one of these guys/gals - good luck. Getting in and out of the market is a loser. This is because there is no way to see market spikes and down turns. There are many behavioral studies that have been done that show people do the wrong thing: they sell after losses have occurred and they buy after the market has gone up. Missing an up spike and not being in before the spike is as devastating as missing a down turn and not getting out in time. There is another down side, if you are trading in a personal account, rather than a tax deferred account, going in and out of stocks has tax complications. In short, a broad based equity index will, over time, beat about anything out there and it will do it in a tax efficient manner.  Exchange traded funds (ETFs) are a wonderful way to obtain diversification immediately at very low cost. Picking yourself is just what all the fund managers are trying to do, and history shows that the majority of them fails the majority of the time to beat the index fund. That is the core reason of the current run after index funds. What that means is that although it doesn’t sound so hard, it is not easy at all to beat an index consistently. Of course you can assume that you are better than all those high-paid specialists, but I would have some doubt. You might be luckier, but then you might be not. As Ross says, SPX is the index itself. This carries no overheads. It is defined as a capitalization-weighted mixture of the stocks of (about) 500 companies. SPY is an index fund that tries to match the performance of SPX. As an index fund it has several differences from the index: In most mutual funds you delegate voting rights to the investment manager.  The securities are typically held by a third party bank as part of the requirements for Securities Investor Protection Corporation (SIPC).  You own equity in that mutual fund, which owns the shares (but are held by a third party); you don't have direct ownership as in most cases that would result in you owning fractions of shares. Mutual funds buy (and sell) shares in companies in accordance with  the policies set forth in their prospectus, not according to the  individual needs of an investor, that is, when you invest money in (or withdraw money from) a mutual fund,  the manager buys or sells whatever shares that, in the manager's judgement,  will be the most appropriate ones (consistent with the investment policies). Thus, a large-cap mutual fund manager will not buy the latest hot small-cap stock that will likely be hugely profitable; he/she must choose only between various large capitalization companies. Some exchange-traded funds are fixed baskets of stocks. Suppose you will not invest in a company X as a matter of principle. Unless a mutual fund prospectus says that it will not invest in X, you may well end up having an investment in X at some time because the fund manager bought shares in X. With such an ETF,  you know what is in the basket, and if the basket does not include stock in X  now, it will not own stock in X at a later date. Some exchange-traded funds are constructed based on some index and track the index as a matter of policy. Thus, you will not be investing in X unless X becomes part of the index because Standard or Poor or Russell or somebody changed their minds, and the ETF buys X in order to track the index. Finally, some ETFs are exactly like general mutual funds except that you can buy or sell ETF shares at any time at the price at the instant that your order is executed whereas with mutual funds, the price of the mutual fund shares that you have bought or sold is the NAV of the mutual fund shares for that day, which is established based on the closing prices at the end of the trading day of the stocks, bonds etc that the fund owns.  So, you might end up owning stock in X at any time based on what the fund manager thinks about X. "I hope a wall of text with citations qualifies as ""relatively easy."" Many of these studies are worth quoting at length. Long story short, a great deal of research has found that actively-managed funds underperform market indexes and passively-managed funds because of their high turnover and higher fees, among other factors.  Longer answer: Chris is right in stating that survivorship bias presents a problem for such research; however, there are several academic papers that address the survivorship problem, as well as the wider subject of active vs. passive performance. I'll try to provide a brief summary of some of the relevant literature.  The seminal paper that started the debate is Michael Jensen's 1968 paper titled ""The Performance of Mutual Funds in the Period 1945-1964"". This is the paper where Jensen's alpha, the ubiquitous measure of the performance of mutual fund managers, was first defined. Using a dataset of 115 mutual fund managers, Jensen finds that The evidence on mutual fund performance indicates not only that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance. Although this paper doesn't address problems of survivorship, it's notable because, among other points, it found that managers who actively picked stocks performed worse even when fund expenses were ignored. Since actively-managed funds tend to have higher expenses than passive funds, the actual picture looks even worse for actively managed funds. A more recent paper on the subject, which draws similar conclusions, is Martin Gruber's 1996 paper ""Another puzzle: The growth in actively managed mutual funds"". Gruber calls it ""a puzzle"" that investors still invest in actively-managed funds, given that their performance on average has been inferior to that of index funds. He addresses survivorship bias by tracking funds across the entire sample, including through mergers. Since most mutual funds that disappear are merged into existing funds, he assumes that investors in a fund that disappear choose to continue investing their money in the fund that resulted from the merger. Using this assumption and standard measures of mutual fund performance, Gruber finds that mutual funds underperform an appropriately weighted average of the indices by about 65 basis points per year. Expense ratios for my sample averaged 113 basis points a year. These numbers suggest that active management adds value, but that mutual funds charge the investor more than the value added. Another nice paper is Mark Carhart's 1997 paper ""On persistence in mutual fund performance"" uses a sample free of survivorship bias because it includes ""all known equity funds over this period."" It's worth quoting parts of this paper in full: I demonstrate that expenses have at least a one-for-one negative impact on fund performance, and that turnover also negatively impacts performance. ... Trading reduces performance by approximately 0.95% of the trade's market value.  In reference to expense ratios and other fees, Carhart finds that The investment costs of expense ratios, transaction costs, and load fees all have a direct, negative impact on performance. The study also finds that funds with abnormally high returns last year usually have higher-than-expected returns next year, but not in the following years, because of momentum effects. Lest you think the news is all bad, Russ Wermer's 2000 study ""Mutual fund performance: An empirical decomposition into stock‐picking talent, style, transactions costs, and expenses"" provides an interesting result. He finds that many actively-managed mutual funds hold stocks that outperform the market, even though the net return of the funds themselves underperforms passive funds and the market itself.  On a net-return level, the funds underperform broad market indexes by one percent a year. Of the 2.3% difference between the returns on stock holdings and the net returns of the funds, 0.7% per year is due to the lower average returns of the nonstock holdings of the funds during the period (relative to stocks). The remaining 1.6% per year is split almost evenly between the expense ratios and the transaction costs of the funds. The final paper I'll cite is a 2008 paper by Fama and French (of the Fama-French model covered in business schools) titled, appropriately, ""Mutual Fund Performance"". The paper is pretty technical, and somewhat above my level at this time of night, but the authors state one of their conclusions bluntly quite early on: After costs (that is, in terms of net returns to investors) active investment is a negative sum game.  Emphasis mine. In short, expense ratios, transaction costs, and other fees quickly diminish the returns to active investment. They find that The [value-weight] portfolio of mutual funds that invest primarily in U.S. equities is close to the market portfolio, and estimated before fees and expenses, its alpha is close to zero. Since the [value-weight] portfolio of funds produces an α close to zero in gross returns, the alpha estimated on the net returns to investors is negative by about the amount of fees and expenses. This implies that the higher the fees, the farther alpha decreases below zero. Since actively-managed mutual funds tend to have higher expense ratios than passively-managed index funds, it's safe to say that their net return to the investor is worse than a market index itself. I don't know of any free datasets that would allow you to research this, but one highly-regarded commercial dataset is the CRSP Survivor-Bias-Free US Mutual Fund Database from the Center for Research in Security Prices at the University of Chicago. In financial research, CRSP is one of the ""gold standards"" for historical market data, so if you can access that data (perhaps for a firm or academic institution, if you're affiliated with one that has access), it's one way you could run some numbers yourself." "That's weird, because I think of money managers as people who ""manage money"". Based on the history of the Medallion Fund, the fund seems to consistently turn money into ""more"" money, and rarely seems to turn it into ""less"" money, which seems to indicate that it's pretty good at ""managing"" the ""money"" that it's been entrusted with." News-driven investors tend to be very short-term focussed investors. They often trade by using index futures (on the S&P 500 index for instance). Nobody tracks a single company's net assets on a daily basis, and stock prices are almost never derived directly from their assets (otherwise there would be no concept of 'growth stocks').  Stocks trade on the presumed current value of future positive cash flow, not on the value of their assets alone. Funds are totally different.  They own nothing but stocks and are valued on the basis on the value of those stocks.  (Commodity funds and closed funds muddy the picture somewhat, but basically a fund's only business is owning very liquid assets, not using their assets to produce wealth the way companies do.) A fund has no meaning other than the direct value of its assets.   Even companies which own and exploit large assets, like resource companies, are far more complicated than funds: e.g. gold mining or oil extracting companies derive most of their value from their physical holdings, but those holdings value depends on the moving price and assumed future price of the commodity and also on the operations (efficiency of extraction etc.) Still different from a fund which only owns very liquid assets.