Index-based ETFs and index funds are popular choices for investors these days. The low costs and simplicity are a big selling points. Not to mention the fund marketing blitz reminding us how often actively managed funds fail to beat the S&P 500 index. But do you know how that underlying index works? Is it built to be a good investment strategy? Or should alternative index weighting methods be used?
A stock index is used to measure the performance of a group of stocks. To do this a weighting method is used, which puts more emphasis on weighting on stocks that meet specific criteria. In turn, those stocks represent a greater part of the index.
Since index funds are built to track a specific index, a fund uses the same weighting method on the stocks it owns.
Most of the major market indices are based on a market cap weighting. In the past few years, several fund companies started offering alternative weighted index funds. But it all started with a price-weighted index. Continue Reading…