Editorial
A general-purpose guide to the kinds of indexes that index funds follow, including weighting methods, scope and dividend treatment, and what to check when reading one.
Contents
An index fund is an investment trust that aims to move in line with a particular index. That means the index it follows largely determines how the fund behaves and what it holds. This article gives a general overview of the kinds of indexes and how to read them. It does not recommend any specific index or fund.
What an index is
An index expresses the movement of a whole market or a specific segment as a single number. Prices of many securities are combined using fixed rules, a starting date is set at a base value such as 100 or 1,000, and later changes are measured against it.
An index fund holds securities that follow the makeup of the index and tries to produce similar returns. However, an investor cannot buy the index itself, and the fund bears running costs, so its results will not match the index exactly.
Main types of index
Indexes can be grouped by what they cover and how they are calculated.
| Way of grouping | Examples | Characteristics |
|---|---|---|
| Asset class | Stocks, bonds, REITs | Size of price swings and sources of return differ by asset class |
| Region | Domestic, developed markets, emerging markets, global | A wider region spreads risk more, but currency effects may be added |
| Scope | Whole market, large caps, small and mid caps, sectors | The narrower the scope, the stronger the influence of one area |
| Weighting method | Market-cap weighted, price-weighted, equal-weighted | Determines which constituents move the index most |
How the weighting method changes things
Even with the same group of companies, a different weighting method produces a different index.
- Market-cap weighted: the larger a company’s market value, the greater its influence. This tends to reflect the market as a whole, though a small number of very large companies can dominate. Japan’s TOPIX is close to this approach.
- Price-weighted: the calculation is based on the share price level itself, so higher-priced shares carry more influence. The Nikkei 225 is close to this approach.
- Equal-weighted: each constituent gets the same share. Smaller companies have relatively more influence, but regular rebalancing involves effort and cost.
Even for the same market, then, two indexes can move differently over a given period, which is why the name alone is not enough to judge a fund.
Checkpoints when reading an index
Looking beyond the name to the calculation method and composition makes a fund’s character clearer.
- Number of constituents and the weight of the top holdings: how concentrated the index is in a few names.
- Treatment of dividends: whether the index is a total return version that includes dividends, or a price index that shows only price changes. The total return version is closer to what an investor actually earns.
- Currency: whether the index is in yen or a foreign currency. Foreign assets bring currency effects, and it is worth checking whether the fund hedges them.
- Reconstitution rules: when and by what criteria constituents are changed.
- Provider: who calculates and publishes the index, and how openly the rules are disclosed.
Calculation rules can be found in the prospectus or in documents from the index provider. Costs are shown separately in the fund documents, so the index description and the fee table are best read together.
Indexes are not limited to stocks. A bond index, for example, is built from the prices and interest payments of government or corporate bonds and can be sensitive to changes in interest rates. A REIT index follows the prices of real estate investment trusts. Because asset classes differ in the size of their price swings and in how they react to the economy and interest rates, the first step is to confirm what an index actually covers.
Two indexes that both describe themselves as covering domestic stocks may in fact differ, with one centered on large companies and the other including a broader range of small and mid-sized firms. Depending on the economic phase, one may rise while the other lags. The useful question is not which is better, but whether the range matches the part of the market you intend to hold.
Why a fund differs from its index
The return of an index fund does not match the index exactly. The main reasons are as follows.
- Fees such as the management fee are deducted from the fund’s assets.
- It may not be practical to hold every constituent at exactly the same ratio.
- Trading costs arise when constituents are replaced.
- For overseas assets, currency and local tax treatment can create differences.
This gap is often called tracking error and may be visible in the management report. Hypothetically, if an index rose 10.0% in a year and the fund rose 9.6%, the difference is 0.4 percentage points, which is likely to include the effect of fees and similar items. The size of the gap varies between funds, so looking at several years is useful.
A practical way to use this is to place the index description from the prospectus next to the fund’s reported results. If the fund consistently trails by more than its stated fees would explain, it may be worth finding out why before relying on it.
Finally, remember that an index changes over time. Constituents are added and removed, and weights shift as prices move, so the composition you read about today may not be identical a few years from now. Checking the index description again when you review your holdings keeps your understanding current, and it is a simple habit that requires no forecasting.
Points to consider and risks
- An index is only a yardstick: if the index falls, the fund falls too, and the principal is not protected.
- An index is not always diversified: some indexes lean toward certain companies, sectors or regions.
- Past movement does not assure the future: how an index has behaved says little about what comes next.
- Names can mislead: indexes with similar names can differ in coverage and calculation.
- Balance with cost: compare the index features together with the fund’s fees.
Which index to follow depends on your goals and how much price movement you can tolerate. After weighing both benefits and risks, the decision is yours. For how this site treats information, see the editorial policy and the disclaimer.
About this article: This is a basic guide article. Our policy is to check the content against public sources. It is not investment advice. If you notice an error, please contact us.