How index funds are created and managed? [video]

It's by expert committee not computer design

    Who decides which stocks are in an index fund?

    Contrary to popular belief, an index fund is not created by a computer or speculative guesswork - as this video explains, index funds are created, managed and reviewed by a highly professional committee of experts...

    Understanding how index funds are created and managed

    Robin Powell: A common misconception about index funds is that they’re run by computer. In fact, they’re managed by a committee of experienced financial professionals.

    David Blitzer is Chairman of the Index Committee at S&P Dow Jones Indices. I started by asking him, what is the committee’s objective?

    David Blitzer: The objective of the committee is very different from the objective of a money manager or a portfolio manager. A portfolio manager wants to make money, he wants high returns and that’s perfectly reasonable and very fair. But the index committee is interested in making sure the index reflects the market and is a proper measure of the market. And, if the index has a particular objective, in the case of the 500 it’s the U.S. large-cap market, it should do that. If we had stocks in the 500 that were much too small we wouldn’t be doing our job, we would not be reflecting the U.S. large-cap market. If we had an index that’s designed to choose stocks that pay high dividends and that’s very popular in the last several years, you want to make sure the stocks do pay high dividends, otherwise, they don’t belong in there.

    RP: So, how does an index committee decide on which stocks go into a particular index? Well, it has to abide by very strict criteria.

    DB: You shouldn’t get the idea that we’re sort of flipping coins and throwing darts or anything like that. First, there are clear criteria for including a stock in the S&P 500. It has to be a U.S. company, it has to be profitable, based on GAAP ‘generally accepted accounting principles’ over the last four quarters summed together, and the most recent quarter. Nobody wants to buy companies that lose money. The stock has to be liquid and to be in the 500 it has to be reasonably large about $6.5 million or more in market capitalisation.

    RP: Far from being set in stone, an index has to be constantly monitored and maintained. Somewhere around 15 to 20 times a year, a new stock will enter the index and another one will make way for it.

    DB: What we’ve seen, or what I’ve seen, because I’ve sat at the committee and actually chaired it for over two decades, is the ability to choose the stock and debate it among a group of professionals who talk about it and see what’s happening in the market. Each one brings his own perspective on what’s going on. Really does a very good job of having an index that reflects the market overall and what’s going on in the market. Looking at the investment results, it turns out, more often than not, most so-called active managers don’t do as well.

    RP: That’s it. Thank you to David Blitzer from S&P Dow Jones Indices, and to you for watching.

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