3/23/17

Index Fund History, Types, and Definitions Explained

In our last Indexes and Your Investments blog post, we reviewed what makes the most popular index funds rise above the rest and how the individual stocks in these popular index funds are selected. In this blog post, we’ll review some of the history behind index funds, as well as explore the many types of index funds that exist today.

The World’s First Index Fund

The world’s first index fund was the Dow Jones Average, which first appeared in media on July 3, 1884. The index fund was assembled to measure the overall performance of active companies and consisted of 11 commodity-based companies -- nine of which were railroads. Although the Dow tracks more stocks today, it still uses the same methods as it did in 1884 to measure market performance and the number of stocks it tracks has remained the same since 1928.

Many criticize the Dow for its obstinate ways, including James Mackintosh, a senior market columnist for The Wall Street Journal, who said “It’s time to ditch the Dow. After 120 years, the venerable Dow Jones Industrial Average is an embarrassing anachronism, abandoned by professionals and beloved only be a media that mostly knows no better. It needs to be updated or, better, replaced.”

Despite its flaws, the Dow remains to this day one of the most popular index funds. Not all index funds are modeled like the Dow, however. There are many different ways to calculate and assemble index funds that we’ll explore in detail below.

What are the Different Types of Index Funds?

Index funds use many different methods to measure market performance. Here are a few ways index funds are calculated:

Price weighted: Price weighted index funds give more weight to stocks with higher share prices and lesser weight to stocks with lower share prices. The Dow is an example of an index fund that is price weighted.

Market cap weighted: This is the most common weighting system used. Market cap weighting multiplies a company’s share price by the total number of its outstanding shares, which gives more weight to the bigger, more influential companies in the market. Large cap stocks are typically those with a market cap of $10B or more, mid cap stocks are those with market caps between $2B and $10B, and small cap stocks are those with a market cap between $300,000 and $2B.

Equal weighted: As the name implies, each company’s stock carries equal weight, no matter how large or small the holding. In an equal-weighted version of the S&P 500, for example, each company’s stock carries 0.2% of the index’s total value.

Using different weighting systems, the same segment of the market can be measured many ways.

What companies are included in an index fund will also change how the market segment is measured. Index funds can contain a broad array of companies spanning several segments or a slim sliver of companies that adhere to certain rules within a narrow slice of the market. They can also include thousands of companies or just a few dozen.  Each of these characteristics can be thought of as a spectrum ranging from one extreme to another:

Highly representative: Some index funds rely on a select few securities to represent a large number of stocks. The Dow, for example, uses a mere 30 securities to represent thousands of U.S. stocks.

Widely inclusive: Other index funds include nearly all securities – both large and small -- within a market segment to gauge the segment. The Wilshire 5000 Total Market Index, for example, contains all U.S. headquartered equities with available price data, covering a wide swath of the market.

Somewhere in between: Most index funds fall somewhere in between the spectrum, tracking a decent-sized number of the larger or hard-hitting companies, but not all of them. The S&P 500, which tracks around 500 publicly-traded U.S. securities, is an example of an index fund that falls somewhere in between.

As you can see, there are many variations of index funds used to measure market performance. The weighting system, number of securities, and types of securities within a fund can tilt the scale one way or another, reinforcing the claim in our first blog post that index funds are simply a model – not a perfect representation – of the market at any given time.

 

The FMB Advisors Blog

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