There are two typical ways to invest in an index fund, plus one way that isn’t.
Buy a mutual fund that mimics the index you want to buy. You technically own shares in the mutual fund, which is an undivided right to a tiny percent of the whole pool. To get your money out, you have to redeem your shares, which happens at the fair market value. (It used to be that redemptions happened at fair market value at market closing price; I don’t know if that is still true.) To fund redemptions, the fund has to keep some cash on hand, so some small percent of your money isn’t actually invested. If you invest in mutual funds in a taxable account, the churn in fund holders’ redemptions create trades that cause capital gains, which creates taxable income for the fund as a whole. It will be a small percent, but it will still be there (on top of taxation of any dividends). This is because the legal model applied to your investment is like you are a partner in a partnership, where you get an allocation of profits and losses that are separate from your receipt of cash.
Buy an exchange traded fund that mimics the index you want to buy. These are still mutual funds in operation. The main difference here is that the shares in the fund are themselves tradable. Theoretically, I think this means that the fund does not have to redeem as much, so it can hold much less cash. It would do redemptions if people were bailing out of the market generally, so that sellers outnumber buyers. But the issuer can essentially make money by arbitraging any difference, which means effectively redemptions pay for themselves. Being exchange traded means that the mutual funds have to make some additional SEC filings, but these have become routine once EFT’s became popular, and the costs are spread over a truly vast number of people. The other main difference is that you only pay taxes on capital gains when you sell your ETF shares. That is because the legal model treats an ETF like an investment in a corporation, where the corporation’s profits and losses are not attributed to you, and you only get something when you get cash.
You can also buy all the shares yourself, which is something called a “synthetic” fund sometimes in rarefied circles. It eliminates all of the potential capital gains taxes until you sell the underlying assets, but it means that you have to buy a set of shares that would be really expensive and only comes in oddly sized chunks. For example, if you want to buy the stocks in the Dow Jones, that is 30 different stocks, any you would have to buy one of each. That might cost you $1,531.72. Who wants to buy investments at a price of $1,531.72 per unit? What do you do if you have $1,500 or $1,600?That is why ETF’s are so attractive. They get all of the convenience of the mutual fund, the capital gains tax treatment of owning shares directly. Index funds, whether regular mutual funds or exchange traded funds, also have the benefit of spreading fixed costs over huge numbers of people, so the expenses are usually very low.
Exchange traded funds are actually a little more clever than that. From the fund’s perspective, it doesn’t redeem fund shares for cash. The ETF has a number of “authorized participants” which are banks that can create new shares of the ETF. To create new shares of the ETF, they purchase the underlying shares in large quantities (called a “creation unit”) and provide them to the ETF, which then gives back the authorized participant the matching number of ETF shares. So for an S&P 500 ETF, the bank would first purchase all of the underlying shares of the S&P500 in the right quantity (generally a very large quantity) and provide them to the ETF, and the ETF would hand them X number of ETF shares that the bank can now sell. The banks make money through arbitrage, by buying and selling creation units when they are out of alignment with the price of the ETF.
A synthetic fund is slightly different from your description. A synthetic index is when you use derivatives to replicate the performance of an index fund. So rather than taking your $100 million charitable endowment and invest it in an index, you take your $100 million dollars and invest it in treasury securities, then enter into a swap contract that will replicate the perfomance of the index. Future payments go into your fund, and future shortfalls are removed from your fund. It can also be done with futures and the like.
There are two typical ways to invest in an index fund, plus one way that isn’t.
Buy a mutual fund that mimics the index you want to buy. You technically own shares in the mutual fund, which is an undivided right to a tiny percent of the whole pool. To get your money out, you have to redeem your shares, which happens at the fair market value. (It used to be that redemptions happened at fair market value at market closing price; I don’t know if that is still true.) To fund redemptions, the fund has to keep some cash on hand, so some small percent of your money isn’t actually invested. If you invest in mutual funds in a taxable account, the churn in fund holders’ redemptions create trades that cause capital gains, which creates taxable income for the fund as a whole. It will be a small percent, but it will still be there (on top of taxation of any dividends). This is because the legal model applied to your investment is like you are a partner in a partnership, where you get an allocation of profits and losses that are separate from your receipt of cash.
Buy an exchange traded fund that mimics the index you want to buy. These are still mutual funds in operation. The main difference here is that the shares in the fund are themselves tradable. Theoretically, I think this means that the fund does not have to redeem as much, so it can hold much less cash. It would do redemptions if people were bailing out of the market generally, so that sellers outnumber buyers. But the issuer can essentially make money by arbitraging any difference, which means effectively redemptions pay for themselves. Being exchange traded means that the mutual funds have to make some additional SEC filings, but these have become routine once EFT’s became popular, and the costs are spread over a truly vast number of people. The other main difference is that you only pay taxes on capital gains when you sell your ETF shares. That is because the legal model treats an ETF like an investment in a corporation, where the corporation’s profits and losses are not attributed to you, and you only get something when you get cash.
You can also buy all the shares yourself, which is something called a “synthetic” fund sometimes in rarefied circles. It eliminates all of the potential capital gains taxes until you sell the underlying assets, but it means that you have to buy a set of shares that would be really expensive and only comes in oddly sized chunks. For example, if you want to buy the stocks in the Dow Jones, that is 30 different stocks, any you would have to buy one of each. That might cost you $1,531.72. Who wants to buy investments at a price of $1,531.72 per unit? What do you do if you have $1,500 or $1,600?That is why ETF’s are so attractive. They get all of the convenience of the mutual fund, the capital gains tax treatment of owning shares directly. Index funds, whether regular mutual funds or exchange traded funds, also have the benefit of spreading fixed costs over huge numbers of people, so the expenses are usually very low.
Exchange traded funds are actually a little more clever than that. From the fund’s perspective, it doesn’t redeem fund shares for cash. The ETF has a number of “authorized participants” which are banks that can create new shares of the ETF. To create new shares of the ETF, they purchase the underlying shares in large quantities (called a “creation unit”) and provide them to the ETF, which then gives back the authorized participant the matching number of ETF shares. So for an S&P 500 ETF, the bank would first purchase all of the underlying shares of the S&P500 in the right quantity (generally a very large quantity) and provide them to the ETF, and the ETF would hand them X number of ETF shares that the bank can now sell. The banks make money through arbitrage, by buying and selling creation units when they are out of alignment with the price of the ETF.
A synthetic fund is slightly different from your description. A synthetic index is when you use derivatives to replicate the performance of an index fund. So rather than taking your $100 million charitable endowment and invest it in an index, you take your $100 million dollars and invest it in treasury securities, then enter into a swap contract that will replicate the perfomance of the index. Future payments go into your fund, and future shortfalls are removed from your fund. It can also be done with futures and the like.