In theory, index funds are very simple. Rather than trying to pick individual stocks as winners or losers, you pick sectors of competing companies in the economy and bet that the sector will improve over time, even if individual companies don't compete. Exchange Traded Funds (ETF) are purchasable just like individual stocks.
In many ways, an index fund is like a mutual fund, and they have similar performances. It should be noted that over the long term, index funds outperform about 80% of all of the hedge funds and mutual funds out there. The second advantage of an index fund is lower fees. An index fund doesn't have to keep a battalion of MBAs on staff to predict trends in the chaos of the markets, and the resulting lower fees are part of the appeal.
The Three Kinds of Index Funds
With wider acceptance of index funds out there, there are more options available as investment brokerages try to differentiate their products. The three primary types of index funds use wither market-capitalization weight (cap weight), equal weight, or fundamental weight to pick which companies get investment money.
Market Capitalization Weight Index Funds
The most common of the three, cap weighted funds allocate larger percentages of their investment capital in an index in proportion to the money the company spends annually. This weights by the size of the business, and generally reduces volatility, but at the expense of growth.
Equal Weight Index Funds
In an attempt to capitalize on the better growth potential of mid-cap and low-cap firms, equal weight index funds spread their investing out on a per share basis, meaning every firm invested in gets the same weight; there's no hedging the bet in favor of larger, more stable companies. This strategy works well when the market is going up, but there is more volatility.
Fundamental Weight Index Funds
The third type of index fund is closer to being a mutual fund. A fundamental weight fund screens companies based on a set of criterion - these can be book value, earnings, total revenue, or dividend rate of return. Companies that score higher on this screening get a larger allocation of the funds capital. This can allow a fund to score big on an under-valued firm in the market without taking too much risk.
Choosing an Index Fund
Choosing the right fund largely depends on how much volatility you're willing to put up with. Cap-weighted funds have the least risk, while fundamental-weighted funds let you choose something that might have more growth potential. There's nothing keeping you from spreading your allocation among different index funds, going for growth early in an investment cycle, and then shifting to cap-weighted funds as your goals are met. One downside of newer fund types is that they usually have higher fees, and the lower fees on index funds are often more valuable than their sector-driven performance.
The immediate trend among investment brokerage firms is towards ever increasing index fund complexity. No matter how they try to differentiate their product, you should ask for transparency, and the rules by which they select stocks and allocate funds to them. As in all investing, assess how much risk you're willing to take, and always ask for more information about investment vehicles.
