The Fundamentals of Index Funds: What You Need to Know
June 25, 2018
By Colin O'Shea • Securities Analyst
In many cases, index funds outperform other forms of investments. But before you choose which index fund(s) to invest in, be sure you know the fundamentals of what an index fund actually is.
What Exactly is an Index Fund?
An index fund is a type of mutual fund that, instead of relying on an individual portfolio manager, depends on a committee or special formula to choose which group of stocks to invest in. There are several types of index funds, with the main difference being how the funds are structured:
EQUAL-WEIGHTED Index FUNDS
An equal-weighted fund holds each stock in the index in equal proportion, no matter the market cap of the stock. With this method, periodic rebalancing generally is required, resulting in transaction costs. As a result, equal-weighted funds tend to be more expensive than cap-weighted funds.
Cap-Weighted Index Funds
Cap-weighted funds tend to emphasize larger companies more than smaller companies. This method generally is less expensive and more tax efficient than other methods. With a fund that uses market-capitalization weighting, the amount of each stock held in the fund reflects the stock's representation in the underlying index based on market value (or capitalization).
Fundamental Index Funds
Stocks in a fundamental index fund are weighted based on factors such as dividend yield, earnings, or book value. This method can allow a fund to emphasize a certain investing style, such as value or income. Fundamental index funds also require periodic rebalancing that results in transaction costs.
With price-weighted funds, stocks are represented based on the share price of each company in the underlying index. Because the price-weighting method generally requires less trading than the equal-weighting and fundamental indexing methods, costs are typically lower than they are with either of those methods.
Want to Learn More about Index Funds?
You should always read an index fund prospectus carefully before you invest or send money in that index fund. And remember, shares, when redeemed, may be worth more or less than their original cost. Contact us and one of our Investment Advisors can help you understand more about a particular index fund's investment objectives, charges, expenses, and risks.