Different index funds are weighted in a different way. Whatever type of index fund or funds you choose, make sure you understand the methodology, so you can stay away from an investment that doesn't behave the way you expected.
Representing nearly 15% of all mutual fund assets today, index funds have become an increasingly popular choice for investors. The first index fund, introduced by Vanguard in 1976, tracks the S&P 500, and today that index is by far the most popular one used, accounting for about 37% of all index fund assets.
The core premise behind index investing is that beating the market consistently over the long term through actively picking stocks that will outperform is extremely difficult. Instead, the most basic index funds seek to capture the market's performance itself in the belief that the investors who participate in it are fundamentally rational and also value stocks at or near their fair values.
In some cases, if an index is too broad or securities in it too illiquid for a fund to adequately track, the fund's manager might try to mimic the index's performance through a technique called representative sampling.
Although index funds seem to track anything and everything, there are a few primary ways of constructing them, from conventional market-cap weighting to alternative methods such as equal, fundamental, or price weighting.
By far the most common method of indexing is through market-cap weighting, in which the amount of each stock held is proportionate to its market value, or capitalization. So if a stock's market cap makes up 5% of an index, it also makes up 5% of the fund's portfolio.
The method provides an accurate reflection of how the market looks, with greater emphasis on bigger companies (by cap weight) and less on smaller companies; as stocks grow, they naturally take on a larger percentage of the index without the fund needing to buy new shares, making this method cheaper and more tax-efficient than others.
In rising markets, the index might include a higher percentage of overpriced stocks. The method emphasizes the biggest companies, which might have less room to grow than the smaller companies that make up less of the index.
All stocks are held in equal proportion regardless of market cap. So, for example, an equal-weighted S&P 500 fund would still include the same 500 stocks as the cap-weighted version, but in equal amounts--in this case each making up 0.2% of the index.
The method provides a greater tilt to midsized companies, which sometimes offer better returns than the largest companies.
By overweighting smaller companies, the index no longer accurately represents the market. The portfolio must be rebalanced periodically--typically quarterly--which creates transaction costs and means the index might fall out of equal-weighting for months at a time. Equal-weighted funds are generally more expensive than cap-weighted index funds.
Stocks are weighted based on a fundamental metric or metrics, such as dividend yield, earnings, book value, or a combination of factors.
The method can be used to provide a tilt to an index (toward value or income, for example) while generally avoiding the negative effects of stocks becoming overvalued by the market.
Fundamental indexing does not serve as a proxy for the market. It requires rebalancing that can add transaction costs, and funds that employ this method tend to be more expensive than cap-weighted index funds.
Stocks are weighted by the share price for each company in the index, with the Dow Jones Industrial Average the most famous example.
The method requires less trading than equal-weighted or fundamental indexing methods, which helps reduce costs.
The index can become skewed toward overpriced stocks and detached from market values.