Arguments for and against Weighted Index Investing

There are two types of weighted-index investing: capitalization-weighted index investing and fundamentally weighted index investing. Both involve the same principal strategy. The investor finds a fund that focuses on a certain index and purchases shares in that fund. As long as the index grows, the fund grows, providing low risk and relatively stable rewards to the investor. Depending on how the index is weighted, though, there can be unique advantages or disadvantages to this tactic. 

Capitalization-Weighted Indices

A capitalization-weighted index relies on the efficient market hypothesis to pick profitable securities. The S&P 500 is an example of a capitalization index. It assumes that the price of a security is accurate because investors are setting this price based on all information available on the security. According to this argument, individuals are reasonable, and thus, they are setting the prices reasonably. Investing in this type of index strategy should provide healthy returns.

However, capitalization-weighted indices do not account for undervalued and overvalued stocks. In reality, there is little evidence investors do act rationally based on the information at hand. Rather, there is evidence of speculation and distortion in the market. Therefore, some stocks are overpriced, and some are under-priced. Proponents of the capitalization model believe these two forces balance each other out. But there is evidence that points to the opposite and may indicate capitalization funds are simply not highly profitable or maneuverable. 

Fundamentally Weighed Indices

To compensate for the fact that markets are often inefficient, new indices are using the fundamentally weighted option to try to better estimate the actual value of a given group of securities. This model takes into account things like corporate talent, market trends and the effects of the involvement of hedge funds and other groups in distorting the market. The formulas and information compiled by each index to determine the value of a stock is proprietary, but all rely on detailed analysis. This eliminates the presence of overpriced securities, concentrating on those securities with plenty of room for growth, perhaps promising larger returns. Fundamentally weighted indices promise to be the solution to market speculation, and many believe they will deliver on this lofty goal.

Unfortunately, fundamentally weighted indices are very young, so there are few funds available using this method. The results of these funds have not been analyzed over time in comparison to capitalization-weighted indices. Therefore, there is not a wealth of evidence either way to support one type of weighting. While that would not be a major problem for most investors, the fact is that fundamentally weighted investing tends to be more costly. The funds are much smaller, since they are younger, so the burden of cost is shared by fewer investors. Fundamentally weighted indices have more movement, meaning there will be more transaction fees driving up this cost. It can be hard to determine whether the cost will be worth the investment at this point. If you would like to try fundamental funds, you will have to be willing to incur a higher cost on the front end without an immediate promise of greater rewards.

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