When you buy an index fund you are outsourcing your stock selection to a rulebook written by an index provider. It is worth knowing what is in that rulebook, because "passive" does not mean "no decisions were made" — it means someone else made them.

An index is three rules

  1. Eligibility — who is allowed in. Country, exchange listing, minimum size, minimum liquidity, sometimes profitability or free float.
  2. Weighting — how much of each. Almost always by market capitalisation, adjusted for free float.
  3. Rebalancing — how often the list is redrawn, typically quarterly or semi-annually.

Weighting is the big one

Market-cap weighting gives each company a slice matching its market value. Its great virtue is that it is self-maintaining: as a company grows, its weight grows without any trading, which is why cap-weighted funds are so cheap to run.

Its criticism is equally simple: you automatically own the most of whatever has already risen the most. In a bubble, a cap-weighted index concentrates into the bubble by construction.

The alternatives all cost more to run because they require trading. Equal weighting gives every constituent the same slice and must constantly sell winners to buy laggards. Fundamental weighting uses revenue or book value instead of price.

The committee in the room

Some famous indices are not purely rules-based at all — a committee decides which companies are included. That means human judgement sits inside a product marketed as passive. It is not sinister, but it is worth knowing.

Why the rules reach your portfolio

When a company is added to a major index, every fund tracking it must buy — regardless of price. That is a genuine flow, and it is why index inclusion moves stocks. It also means an index fund is a price-insensitive buyer: it buys because the rules say so, not because anything is cheap.

Summary

Read the index name properly before you buy the fund. "World" often means developed markets only; "500 largest" means largest by float-adjusted cap, decided quarterly by a rulebook. The fund is only ever as sensible as the index behind it.