What Style of Index Investing Is Right for You?
Find out what you need to know about index weightings before you invest
For years, traditional market cap-weighted index funds have been the go-to product for passive investors. Besides being inexpensive, tax-efficient, and transparent, studies show they tend to outperform their actively managed counterparts over the long term.
But over the past several years, alternative forms of indexing, such as fundamental and equal weighting, have gained momentum. These indices preserve some of the low-cost and tax benefits of conventional index funds, but by taking different security weighting approaches, they aim to correct perceived inefficiencies in traditional, market-cap indices to produce better returns.
In the roughly five years since they were introduced, alternative indices have often performed better than their cap-weighted counterparts, but experts caution that investors shouldn't be lured to a particular index style based on performance alone. With each indexing method comes unique benefits and risks. "There's no one style or construction ... that's necessarily better than the others at all times," says
The most predominant form of indexing assigns weights according to a company's market capitalization, or the market value of their outstanding shares. That means companies with the largest market capitalizations have more of a presence in an index than companies with smaller market capitalizations.
For example, consider the weightings of the
The primary benefits of market cap-weighted indices are twofold, says
Because securities shuffle less frequently in market cap-weighted indices, less buying and selling occurs, which keeps trading costs and capital gains taxes (assessed if a security is sold at a gain) to a minimum.
While market-cap weighting is the most entrenched indexing method, critics say it can lead to wild swings and periods of boom and bust, such as what investors experienced during the 90's tech bubble or more recently, the financial sector meltdown in 2008. (Investors in funds tracking the cap-weighted
Nevertheless, experts say market-cap weighted funds still have a place in a well-diversified portfolio. "In a momentum market, cap-weighting is going to win," says
These indices come in two main varieties: equally weighted and fundamentally weighted. As its name suggests, the equal-weighted approach portions out index weights equally so that individual large-cap stocks have just as much weight as individual mid- or small-cap stocks. For example, each holding in Rydex's S&P Equal Weight ETF (symbol RSP), which tracks the
Alternative weighting schemes aim to capitalize on short-term inefficiencies in how the market prices stocks by rebalancing holdings quarterly or annually to account for short-term changes in the market. "Stock prices are driven by people's emotions [and] they move more than the intrinsic values. Stock prices are more volatile than the fundamentals that determine the intrinsic value of a company," says
How do these methods stack up to traditional cap-weighted approaches performance-wise? Roughly five years after their inception, alternative indices have beaten their cap-weighted counterparts in many cases. According to
However, because the group has a relatively short track record, many experts have reservations about depending on that kind of performance going forward. "They've been performing differently, just like we would expect them to," Justice says. "We've seen the data, we just haven't seen it applied in a broad way to say that this is something that's really going to work. You look back on market cap-weighted indices, they go back to the early 1900s and you can clearly see that stocks are a pretty good investment."
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