Expert: Paul Henneman - 8/19/2010

Question
QUESTION: Hi,

I recently purchase an index fund locally but when I check
and call the bank, the bank officer can't and don't know the
answer I ask for.

I ask them how an index fund company operate and earn money,
I know they are charging approximately 0.15% average to make
money but the question I have is when we bought the index
fund from the stock market or during listing time the money
index fund company collected via IPO will all purchase back
to the share market or how ?

For example the Vanguard 500 index fund, did Vanguard really
purchase 500 shares from the market during IPO ?

Thanking in advance!

ANSWER: Thank you for your question!
I am not quite certain what you are asking here, your question is not entirely clear to me. It appears that you may not understand fully what an index fund is?

There is no relation to an IPO (intial public offering) when you buy an index fund. An IPO is a stock that is released to be traded on the stock market for the first time. This has nothing to do with an index fund.

The Vanguard 500 Index fund is a good example. However, the 500 does not indicate the number of shares purchased from the market.  

An index fund copies a stock market index. For example, the Standard and Poors 500 (commonly referred to as the SandP500) is a group of 500 stocks that are tracked all together to give an indication of overall stock market performance based on that entire group of stocks. In this case, the S&P500 are large cap stocks, meaning big, established companies. Investors can estimate approximately an average market return for large companies by watching the S&P500 index.

An index mutual fund copies an index, in this case the S&P500. This means that the mutual fund is holding those 500 stocks as investment, so when you purchase shares in this mutual fund, the performance of your investment will very closely match the overall performance of the index.

How they do this is a bit complicated. Here is a link to this mutual fund for some descriptions:
https://personal.vanguard.com/us/FundsSnapshot?FundId=0040&FundIntExt=INT

YOur investment will not exactly match the index, because the fund takes out some fees and other small differences. But it will be very close.

Index funds are used when you want a general investment that will track the overall performance of the stock market, as tracked by that index, in this case large companies. There are also indexes that track small companies, or specific sectors in the economy like technology, or other segments of the overall market. There are mutual funds that allow you to effectively invest in these other indexes also.

I often recommend the book "Investing for Dummies". It is a good book, that provides the basic information you need to understand things like index mutual funds. It is available on amazon.com and in most major bookstores.

I hope this helps!  Please do not hesitate to follow up with me if I can be of any additional service,

Sincerely,
Paul Henneman
President
ValuEngine Inc
www.ValuEngine.com


---------- FOLLOW-UP ----------

QUESTION: Hi, Paul

Thanks for your quick reply and detail explanation to me is
much appreciated.

I still don't understand, as we can purchase the Index Fund
just like any other stocks in the stock market, the price of
the Index Fund then is thus driven by supply and demand and
I write here an example here :

I buy Vanguard 500 Index Investor at 10:00am @ USD100.00 X
100 shares.

and after that,
I buy Vanguard 500 Index Investor at 10:05am @ USD105.00 X
100 shares.

and after that,
I buy Vanguard 500 Index Investor at 10:10am @ USD110.00 X
100 shares.

and after that,
I buy Vanguard 500 Index Investor at 10:20am @ USD120.00 X
100 shares.

and the process keep going until I bought at the closing
time at 17:00pm @ USD150.00 X 100 shares.

Is this mean this Vanguard 500 Index Investor increased 50%
value ?

But, the "real" component shares value is not increased by
50% ?

How do we justify this ?

How the Vanguard 500 Index Investor "adjust" back to the
value it supposed to ?

Hope to receive your reply again.
Thanks in advance!

Answer
Thank you for the follow up question!

An index mutual fund, such as the one you use in your example, does function just like a stock. The only difference is that the price represents the overall value of 500 stocks, averaged together.  If there is a good day in the markets, then most of those 500 companies will go up in price, so the price of the index fund will go up. The same can happen in a bad day, where perhaps 300 or more of the stocks in the index go down, bringing down the price of the index, and therefore the mutual fund that is based on that index.

I am not clear regarding your question about how the index fund adjusts back to the value it is supposed to.  There is no inherent value for the fund to adjust to, it is based on the value of the index.  The price for the fund is based on that, it is not supposed to adjust to any other price than that represented by the index.

In actual practice, there are alot more details going on here that make this subject too complex to provide all of the details here. For example, the value of the index is based on the overall performance of the 500 stocks in this particular index. But the computations used are not a simple average, it is much more complex than that.

Here is a link to Standard and Poors website where they provide information on the S&P500 index.  

http://www.standardandpoors.com/indices/sp-500/en/us/?indexId=spusa-500-usduf--p

There are links to view more specifics on how it is computed.  The Index mutual fund you are asking about is designed to copy the performance of this S&P500 index, and its price will adjust accordingly depending upon the overall performance of the S&P500 index.

I hope this is helpful,

Sincerely,
Paul Henneman
President
ValuEngine Inc
www.ValuEngine.com