Investors money goes into the index or etf fund and the index or etf fund manager buys all the stocks in the index or gains equivalent exposure via a derivative replication technique (refer to this article Replication Strategies)
The index does not require anyone to pick which shares to include, all companies meeting the index broad criteria are included within the index by the index provider. But companies can and do drop in and out of the index if they fail to satisfy the index criteria.
Capitalisation Weighted Index Fund
Most share indexes are ‘capitalization weighted’ which tells the funds how much of a particular stock it needs to buy to track the index. That means the portion that an individual stock makes up of the total value of the index is proportionate to its market capitalization, or share price times the number of shares a company has outstanding.
Say for instance General Electric is the largest stock in the Standard & Poor’s 500-stock index, representing 3.99% of the overall index value, while American Greetings was No. 500, at 0.01%. So an S&P 500 index fund then would have 3.99% of its assets in GE stock and lesser amounts of the 499 other stocks. BUT Some indexes are too big for index funds to match exactly. For example The Wilshire 5000 Total Market Index includes 7,000 equities. But funds can come close enough to tracking these benchmarks by buying the largest equities in the indexes and just a statistical sampling of smaller ones. For example the Vanguard Total Stock Market Index Fund, benchmarked to the Wilshire 5000, only holds around 3,400 equities.
As market share prices change the weightings of equities within an index, their matching index-fund portfolios self adjust automatically, so managers don’t have to buy or sell shares thereby saving on transaction costs.
However when stocks are added to or removed from an index (by the owner of the index) fund managers must follow suit. They also must reinvest dividends paid by their portfolio holdings and make adjustments for stock splits and other events.
But at the end of the day compared to most actively run funds, index funds typically keep a very small cash cushion because any money not invested causes “tracking error” with their indexes.
Index ETF Fund Investing Strategy
Whilst index investing is a simple low cost strategy for investors the actual mechanics for fund managers is not so straightforward. Fund managers must sell shares in the correct proportion from their portfolios when investors pull cash out of the funds. When money comes in, managers must buy shares in the correct proportion.