Index Investing Is Best. But What Type Of Index?

Not All Index Funds Are Created Equal

On average, actively managed funds have historically underperformed the market because of increased tax implications and excessive fees, and because analysts often struggle to accurately time the market. To limit these negative effects, most experts recommend investing in passively managed index funds with low fees.

In light of this, index funds have robustly grown in the last decade, with investment firms like Vanguard leading the way. They are a good starting point for investors. However, most investors do not realize that all index funds are not created equal. The design of an index plays an integral part in its fluctuations and an index fund's performance.

In this article, I will analyze the most common type of fund index, delineate both its strengths and weaknesses, and briefly discuss alternative types of fund indices.

The majority of fund indices mentioned in the media, such as the S&P 500, Nasdaq Composite, NYSE and Russell 2000, are capitalization (Cap) weighted. This is an index "whose individual components are weighted according to their market capitalization (i.e, market value), so that larger components carry a larger percentage weighting." This simply means that companies that are worth more make up a larger portion of the index.

First, let's focus on the strengths of this type of index. A cap weighted index only needs to be rebalanced when a company joins or leaves the index, which is infrequent. As a certain stock increases in value, its weight in the index automatically increases, and as it declines in value, the reverse is true. As a result, minimal trading by the fund takes place. Therefore, these funds have lower taxes and transaction fees as costs are only incurred when there is a trade by the fund.

Second, there is little work involved in operating a cap weighted index fund, done mostly by computers executing a set of trading rules. Therefore, managers of these funds usually charge clients a much smaller management fee. For example, Vanguard charges only .06% annually to clients that own VOO, the company's exchange traded fund (ETF) that passively tracks the S&P 500 with automated decisions and actions.

However, there are a number of market theorists that argue cap weighted indices have a design flaw. By overweighting companies that have higher market values, they are systematically overemphasizing the larger companies or overvalued stocks. In other words, both the larger companies and overvalued stocks are having a disproportional effect on the fund's performance compared to smaller companies and undervalued stocks.

In the "Market Anomalies" fall newsletter, I discussed the historical high performance of value and small cap stocks. If this outperformance trend continues, as I believe it will, cap weighted indices may substantially underperform some of their index peers.

Third, index investors should be aware that a relatively small portion of the index fund holdings often make up a large portion of the portfolio. For example, as of November 2011, the stocks of the largest 10 companies in the S&P 500 index (made up of 500 companies) comprised 18.94% of the index holdings. Therefore, an investor in a fund based on the index should at least make sure that they are comfortable with the largest companies represented in the index.

To address the overweighting issue, two other index types were developed: equal weighted and fundamental weighted. The first type equally weights the stock of each company in the index, while the second type uses certain company valuation criteria to weight the index. These two types of index funds provide both benefits and drawbacks.

One benefit is that they provide more pure diversification. More importantly, they do not overweight expensive or higher priced stocks. But a drawback for these index funds is that they need to be rebalanced periodically to maintain the target weighting. As a result, there are slightly higher tax consequences, trading expenses and management fees. For example, RSP, an ETF that tracks the S&P 500 Equal Weight Index, has an annual expense ratio of .40%.

However, this does not imply that cap weighted index funds have underperformed other funds that resolved the index overweighting issue in all circumstances and time periods. For instance, cap weighted index funds did quite well in periods when large cap stocks outperformed small cap stocks, and when momentum played a large role in returns.

Bottom line: in many short term periods, cap weighted index funds have outperformed equal or fundamental weighted index funds. However over the long term, the equal and fundamental weighted index funds have outperformed them. In Chart 1, six well known and influential cap weighted index funds are compared to their equivalent equal weight index funds. Note that fundamental weighted index funds are omitted because they are more difficult to compare since different investment firms use different valuation criteria.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.