Lesson 8.1 · 1 of 5 · Other markets: indices, commodities, currencies, bonds
How to invest in a stock market index: weighting, replication, costs
You invest in an index through a fund that copies it: an ETF or an index fund. Before you choose, read the index rules in the provider’s methodology, check how the fund copies the index (physically or synthetically) and look at the full cost: the ongoing charge plus the fund’s tracking difference.
Terms in this lesson
- Stock market index
- A basket of stocks that shows how a market is doing: S&P 500, DAX, BET.
- Index fund
- A fund that buys every company in an index, in the same proportions.
- Free float
- The part of a company's shares that trades freely on the market.
- Tracking error
- How faithfully a fund copies the index it follows.
How a stock market index is built: market cap, equal weight or share price
In the lesson on the world’s indices you saw what the S&P 500, the FTSE 100 and the DAX contain. Here you look at the rules. Every provider publishes a methodology: which companies get in, how much each one weighs and when the basket changes. A fund that tracks the index follows those rules exactly, so they decide what you end up owning.
| Index | How it is weighted | What else the official document says |
|---|---|---|
| S&P 500 | by market cap adjusted for free float | US companies worth at least $22.7bn (the threshold in force on 28 October 2026), with positive GAAP net income in the latest quarter and over the latest four combined; a committee makes the selection |
| S&P 500 Equal Weight | equally | the same companies as the S&P 500, each set at 0.2% at every quarterly rebalance |
| MSCI World | by market cap adjusted for free float | 1,249 large and mid-sized companies from 23 developed countries, about 85% of each country’s free float market cap (on 30 September 2026) |
| Dow Jones Industrial Average | by share price | 30 stocks, chosen by a committee with no quantitative rules |
| FTSE 100 | by market cap adjusted for free float and foreign ownership limits | the largest 100 companies listed on the London Stock Exchange, reviewed in March, June, September and December |
S&P Dow Jones Indices methodologies for US indices (July 2026) and the Dow Jones Averages (May 2026), the S&P 500 Equal Weight Index page, the monthly MSCI World factsheet, and the FTSE UK Index Series ground rules (v17.4, October 2026) and methodology overview.
Free float is the part of a company’s shares that trades freely. Shares held by a government, the founders or other strategic holders usually do not count. So a company with half its shares in state hands weighs in the index about as much as a company half its size with all its shares on the market.
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Create a free accountPhysical and synthetic replication of an index
Physical replicationthe fund buys the shares
- Full: it holds every company in the index, in the same proportions
- Sampling: it holds a selection chosen to move like the index
- You can see exactly what it owns in the fund’s holdings
- For indices with thousands of small companies, buying them all costs more
Synthetic replicationthe fund gets the return through a swap
- A bank agrees, through a contract (a swap), to pay the fund the index return
- It can copy indices that are hard to buy directly more cheaply
- Counterparty risk: the bank on the other side may fail to pay
- The fund actually holds other assets as collateral
Guidelines from the European Securities and Markets Authority (ESMA) require the prospectus of a UCITS index fund to say whether it uses full or sampled physical replication or synthetic replication, and what that means for your exposure to the index and for counterparty risk.
What an index fund costs: ongoing charge and tracking difference
Definition
What should you measure when you look at the cost of an index fund?
How far the fund falls behind the index over a year: its tracking difference.
The ongoing charge (OCF or TER) is the declared yearly cost, taken out of the fund. But the fund’s result also depends on withholding tax on the dividends it receives, trading costs and income from lending shares. Tracking difference = the fund’s return minus the index return over a year; ESMA requires the fund’s annual report to disclose and explain it. Tracking error is something else: how much that difference varies from one period to the next.
Tracking difference: -0.18 percentage points (an example).
Compare the fund with the right version of the index. Some indices leave dividends out of the calculation (price indices); others reinvest them (total return indices). A fund that collects dividends and reinvests them can look as if it “beats” a price index for that reason alone. The fair comparison is with an index that includes dividends.
What an expensive fund costs you over 20 years
In the lesson on active funds you saw what the SPIVA reports show: after fees, most active funds fell short of their index. Here you look at the same idea from the cost side: what a few tenths of a per cent a year add up to, in money, over 20 years.
Three lines start at £50,000 and grow over 20 years at 7% a year before costs. With a 0.10% yearly cost they reach about £189,900, with 1.00% about £160,357, with 2% about £132,665. Our own example with a constant return; in reality returns vary from year to year.
Lessons are educational. They are not a recommendation to buy or sell. Investing involves risk and you can lose money. Sources: S&P Dow Jones Indices, “S&P U.S. Indices Methodology” (July 2026: weighting by float-adjusted market cap, the $22.7bn threshold from 1 July 2025, the earnings test) and “Dow Jones Averages Methodology” (May 2026: 30 stocks, price-weighted, the committee); the S&P 500 Equal Weight Index page (0.2% at each quarterly rebalance); the MSCI World factsheet at 30 September 2026; FTSE Russell, FTSE UK Index Series ground rules v17.4 (October 2026) and methodology overview; ESMA, Guidelines on ETFs and other UCITS issues (ESMA/2014/937); S&P Dow Jones Indices, SPIVA U.S. Scorecard, year-end 2025 (published 3 March 2026); the S&P 500 return with dividends in 2008, from Aswath Damodaran’s dataset (NYU Stern, updated 5 January 2026). Funds A, B, X and Y and the 7% return are examples.