Investing without Wall Street: The Five Essentials of Financial Freedom

CHAPTER 8

Index Fund Investing: Beyond the S&P 500

According to the Morningstar database, there are now more than 2,200 index funds (including multiple series) tracking over 500 different indexes. About 250 of them are ETFs. Some indexes are broad-based, covering a wide selection of listed stocks. Other indexes are more narrowly focused. They are indexes of industries or asset classes.

Whereas narrowly focused index funds have a place in the investing universe, they are basically sector funds far more appropriate for professionals or stock investors. Invest in them if you understand the sector or industry. But this sort of specialized investing is beyond the scope of this book.

It's far more important that you understand the ways broad-based indexes are weighted. The different methodologies result in significant differences in performance.

This chapter discusses three of the four most popular ways of weighting indexes: capitalization-weighting, equal-weighting, and fundamental-weighting. We won't worry about price weighting, an archaic system that is still used to compute the venerable Dow Jones Industrial Average. (But the Glossary has a summary of price-weighting for the math inclined.)

Indexing—Yes; Market Cap-Weighted Indexes—Not Necessarily

The most common way to weight an index is by capitalization. The index fund weights each stock in its portfolio based on that company's market capitalization. That includes, but is hardly limited to, index funds based on the S&P 500, DJ ...