Imagine a primary school with children of different height and different intelligence. They are competing in a 100-meter race during a charity event and you can make a donation by betting on an individual child or a group of children.
The time the individual child runs is the performance of your selection (you see that we will return to stocks soon). The performance of the group is their average finishing time.
Now an authority figure forms a group out of the 10 tallest children – let’s call it the Big Kid Index. Their performance is obviously the average finishing time of the school’s tallest children. You could determine the same for the smartest children, and both sound impressive.
This is exactly what providers of stock indices are doing: they select the largest companies and call this group a large cap index. It contains the stocks with the largest market value, also called market capitalization – which is what the "cap" stands for.
The reason they select the largest companies is that they offer an easy way to create convincing financial products. At the same time, this system doesn’t require a lot of work from investors: they simply buy the stocks, done.
However, even though such index funds are often called passive, nothing could be further from the truth. Each index is an active selection of stocks. The only difference is that the stocks aren’t selected by a fund manager, but rather by the stock exchange or by a company working with the exchange. If this index is displayed in a fund and if this fund can be traded on the exchange, then it is an «exchange traded fund», usually abbreviated with «ETF».
Investors, therefore, don’t have to differentiate between active and passive funds, but rather between funds that are compiled by an index manager and those compiled by a fund manager.
The question is, therefore, which is the better choice for stock selection: The asset manager or the index manager. This question will be the topic of next week’s post on this blog. Stay tuned!