This has become a common phrase as investors have increasingly invested in indexed products. An indexed product, including various types of funds, is one whose holdings are based on some underlying index.
So, what’s an index? Here’s what Investopedia says:
An index is a method to track the performance of some group of assets in a standardized way. Indexes typically measure the performance of a basket of securities intended to replicate a certain area of the market. These may be broad-based to capture the entire market such as the Standard & Poor’s 500 (S&P 500) or Dow Jones Industrial Average (DJIA), or more specialized such as indexes that track a particular industry or segment. Indexes are also created to measure other financial or economic data such as interest rates, inflation, or manufacturing output.
An index fund holds securities in the same proportion as the index, itself. So, if Stock A comprises 5% of an index, it’ll comprise 5% of an index fund, all else equal.
Let’s use a less technical description. Think of a recipe for a chocolate cake. The recipe card is like the index – it doesn’t change, although the conditions of the kitchen, or your ability to carry out the instructions may. The cake you make based on the recipe is like the index fund. You can make many cakes based on the single recipe card, but the original recipe stays the same. Back to the non-cake stuff, though. Depending on how a fund is constructed and on the usual fluctuations, it will likely not always hold the exact percentage as its underlying index, but it will be close.