Fun fact! What is the plural form of an index?
It is both acceptable. But, the word "indices" has historically been used more frequently. Even if the use of the Americanized plural "indexes" has grown over time, it still seems far less common than "indices" around the world. Yet, according to Google Trends, "indices" is the most popular search word worldwide.
Now let's discuss what a stock index or equity index is
Equities are grouped and priced to a base value at a particular date to create equity indexes, which are an aggregate of statistical importance. An equity index is a collection of securities that have been put together to provide insight into price growth or total return over a given time frame.
A fund applies the exact weighting mechanism on its stocks because index funds are designed to follow a particular index.
The majority of the significant market indices are weighted by market capitalization. Many fund companies have begun offering alternative weighted index funds in recent years. But a price-weighted index was the catalyst for everything.
Four Methodologies and their Pros & Cons
Stock indices or Equity Indices have Four Approaches.
The most popular methodology, known as the "market value" or "capitalization-weighted" index (MWI), is based on the size of each company. These refer to the terms large, mid, and small-cap stocks. It is the standard way of determining a company's size.
Most leading indices, including the S&P 500, uses the market cap weighting method.
Pros
They ought to be more fully represented when evaluating the market's performance. That is accurate.
Cons
As a method of investing, it is absurd. An investor would purchase more of a stock as its price increases and sell the stock as its price decreases, according to a market-cap-weighted index.
Price Weighted Index
It's the oldest and least used index approach, based on the price average of the underlying stock. A stock with a higher price is given more weight in the index.
Pros
The simplicity of calculation is the only benefit.
Cons
The main criticism of a price-weighted approach is that it focuses too much on share price regardless of underlying factors. Additionally, the cost indicates what a buyer is willing to pay. It makes no mention of the index's stocks' overall performance. It is seldom used because of this.
Equal Weighted Index
This is the first of two alternate weightings employed in smart-beta funds. Because each stock is equally important regardless of its fundamentals, market capitalization, or price, said, each stock in the index is weighted equally. In exchange, each stock equally influences the index's performance.
Pros
It reduces the focus on market capitalization. Therefore, the index fund is not compelled to sell more undervalued companies and buy more overvalued equities. Equal-weighted index funds reduce it somewhat, but only partially. Due to the identical weighting of each stock, it just tends to be more unpredictable.
Cons
High turnover is a result of price adjustments. In maintaining an equal balance, shares are continuously acquired and traded. This increases the fund's expense ratio and may also increase your tax liabilities.
Fundamentally-Weighted Index
A fundamentally weighted index emphasizes one or more variables, such as sales, book value, dividends, cash flow, or earnings. Stocks that fit those criteria are given more weight in the index.
Pros
The emphasis on performance factors is its advantage. This eliminates the equal weighing and backward approach randomness that a market cap weighting provides.
Cons
Higher costs become a concern in this index. But, more importantly, any fundamentally weighted index fund needs enough investors to use the exact strategy.
RUN-THROUGH
You can anticipate that other fund families will join if equal-weighted or alternative-weighted funds become increasingly popular. The potential may create some excellent opportunities for sector-specific funds. You can find a different weighting system that matches your investment philosophy with more research.
