As stated above, index funds are a type of mutual fund. Like all mutual funds, when you buy shares in an index fund, you’re pooling your money with other investors to own a share of the company. With an index fund, the pool of money is used to buy a portfolio of assets that replicate the stocks of a target index. Dividends, interest and capital gains are paid regularly to investors.
The fund manager adjusts the share of assets in his portfolio to match the index. In doing so, the fund’s return should match the performance of the target index, before accounting for fund expenses.
Why index weighting is important for index funds
Indices use different weighting strategies to track their underlying assets, and the choice can have a big impact on the performance of an index fund. A price-weighted index takes into account the market price of each asset: the most expensive assets have a higher share in the index than the less expensive assets. The Dow Jones Industrial Average (DJIA) is a price-weighted index: the price per share of each company tracked by the DJIA determines its weight in the index.
During this time, a market capitalization weighted index considers the market capitalization of each asset – the total money invested in the asset, or the so-called market capitalization – to determine its share in the index. The ASX 200 is a market capitalization-weighted index: the market capitalization of each constituent company determines its weight in the index.
Why is this important? A fund that tracks a price-weighted index must adjust its portfolio holdings more frequently, as market prices fluctuate, to track its target index. With a market cap weighting, there is less need to buy and sell to keep the fund aligned with its objective. However, large capitalization assets can have an outsized impact on the performance of the index and any fund based on it.
A equal weight index gives equal weight in its calculation to every asset it tracks, regardless of its price or market capitalization, large or small. For an index fund, this means that no holding has a disproportionate impact, positive or negative, on performance.
