You have probably heard people talk about investing in index funds. But what type of an index fund? Often the category is discussed as if it is one homogenous group when there are a number of different types of indices available. At their core, index funds are investment funds passively managed to replicate the holdings and/or performance of a defined collection of securities (i.e., an index).
The important point to note is index funds are passively managed. This means the fund manager doesn't pick and chose the stocks she thinks will outperform, she just attempts to mirror the holdings in the index. This method of passive investing can provide broad exposure to the market at a very low cost. Not to mention, study after study has shown that active fund managers (i.e., those who do try to pick stocks that will outperform) can't consistently beat their fund's benchmark index.
The rub is how the index is defined. As index investing has become increasingly popular, more and more organizations have developed indices. Now you can find an index tracking almost any sub-group of securities you can imagine. This posting will address what are probably the three most popular methodologies used in creating indices.
Traditional-the most common type of index is a capitalization weighted index where stocks in the index are weighted by their total market value. Examples include the often quoted S&P 500 Index and the Russell 2000 Index. The weight for each stock is its market value as a percentage of the total market value of all securities in the index. This method results in the most highly valued companies having outsized representation in the index. For example, in the S&P 500 index, the top 10 holdings account for about 19% of the index.
Equal Weighted-this is probably the easiest type of index to understand. In an equal weighted index, the securities in the index are all given the same level of representation (or weight). So for example, in an equal weighted S&P 500 index, each stock would represent 1/500 of the total index and the top 10 holdings account for only 2% of the index.
Fundamental-a more recent development, these funds also weight stocks in the index similar to a traditional index, but by different measures. Instead of using the company's market value, a fundamental index uses factors representing the firms "fundamental" footprint in the economy. Most of these indices use multiple factors in determining weightings. Some of the more popular weighting factors are: revenue, dividends, earnings, cash flow, and assets. These funds tend to have a tilt toward smaller stocks and value stocks relative to a traditional index tracking the same collection of stocks.
Each type of index has its own pros and cons. Supporters of fundamental indexing argue this method avoids buying overvalued firms (i.e., firms with high and increasing valuations) and systematically buys undervalued firms. Whereas, supporters of traditional cap-weighted indices will argue this is the true reflection of the overall market and, academically, the most efficient index.
Different market conditions will favor different approaches to indexing. Luckily, as an investor, you can include a combination of indexing styles in your portfolio.