- Below, we outline the main types of index funds and how to choose one appropriately.
- This information is intended for fund managers and financial advisors looking to build passive, active, or hybrid portfolios using index funds.
- FlexFunds offers an asset securitization program to convert index funds into exchange-traded products (ETPs), boosting their distribution on international banking platforms. For more information, feel free to contact our experts.
Since the launch of the worldâs first index fund – the Vanguard S&P 500 – in 1976, these investment vehicles have continued to grow and gain popularity.
In fact, the current index fund market exceeds USD 13 trillion and is projected to reach USD 30 trillion by the end of the decade.
One reason for this explosive growth is the wide variety of index fund types available to investors.
But before diving into the details of each type, itâs important to understand what an index fund actually is.
What are index funds?
In simple terms, an index fund is a collective investment vehicle that aims to replicate the performance of a specific index.
As the U.S. Securities and Exchange Commission (SEC) explains, you can’t invest directly in a market index, âbut because index funds track a market index they provide an indirect investment option.â
Currently, index funds can either be traditional mutual funds (requiring subscriptions and redemptions) or exchange-traded funds (ETFs), which are traded on the secondary market like a stock.
Types of index funds
Today, there are dozens of types of index funds, with the most notable including:
- Market capitalization-weighted funds
- Broad market funds
- Equal-weighted funds
- Sector funds
- Factor-based funds
- Custom index funds
Market capitalization-weighted funds
These index funds track indices that weigh their components based on market capitalization.
This means larger companies carry more weight and have a greater impact on the index fund than smaller ones.
A classic example is the S&P 500, whose top constituents include the worldâs largest corporations: Apple, Nvidia, Microsoft, Alphabet, Amazon, Meta Platforms, and others.
Broad market funds
Broad market funds are similar but aim to include stocks from as many markets as possible.
Their goal is to replicate the performance of an âentire marketâ – be it a country, a segment, or a region – regardless of the weighting method.
Funds like the Russell 3000 or the Wilshire 5000 are examples of these types of index funds.
Equal-weighted funds
Equal-weighted funds also cover multiple companies but assign each one the same weight to avoid imbalance.
Rather than weighing each stock by market value or price, all stocks are equally weighted so each represents the same percentage of the fund.
In the case of the equal-weighted S&P 500, the nearly 500 companies that make it up each represent the same percentage and are not “unbalanced” like in the original average.
Sector funds
In capital markets, sector funds are also widely traded. As the name suggests, these types of index funds focus on specific sectors.
Instead of investing in an entire market broadly, they target specific areas to enhance returns – though at the cost of higher risk.
Examples include funds focused on the financial, healthcare, or consumer goods sectors, among others.
Factor-based funds
Factor-based funds are built around smart beta or factor investing strategies.
To achieve higher returns and âbeat the market,â these types of index funds use additional metrics beyond just market capitalization.
For example, they may consider dividend yield, cash flow, book value, price-to-earnings (P/E) ratio, and other fundamental and technical factors.
Custom index funds
Lastly, among the most popular are custom index funds, which resemble actively managed funds.
Fund managers design specific indexes based on strategies aimed at outperforming the broader market and then create funds to track those custom benchmarks.
They are similar to actively managed ETFs, like Cathie Woodâs popular Ark Innovation fund.
How to choose the right type of index fund
With so many types of index funds available, choosing the right one can be challenging. However, the process becomes simpler by following two key steps:
Conduct in-depth research
First, asset managers must thoroughly research the funds. Itâs essential to understand how theyâre composed, their objectives, how reliable the fund provider is, etc.
Without this information, portfolio strategy becomes largely based on chance – a risky move in finance and investing.
The goal should be to select a basket of funds that align with the investorsâ objectives. For example, a technology-focused index fund may not be suitable to make up 100% of a conservative investorâs portfolio.
Analyze transaction costs
Itâs also crucial to analyze transaction costs. The more actively a fund is managed, the higher the fees. Over the long term, these expenses can significantly erode gains.
According to a SEC example, over 20 years, a 1% annual fee can reduce the value of a USD 100,000 portfolio by about USD 30,000. In comparison, a 0.25% annual fee would reduce the gain by just USD 10,000 – assuming a nominal return of 4% in both cases.
Securitizing index funds with FlexFunds
Regardless of which type of index fund is chosen, itâs important to remember that these investment vehicles can be securitized through companies like FlexFunds.
At FlexFunds, we transform a basket of assets into exchange-traded products (ETPs) backed by internationally renowned providers, in a cost-efficient manner.
We also offer an all-in-one service, including:
- Stock exchange listing
- Fund accounting
- Back-office services
- Net Asset Value (NAV) calculation
- Corporate administration services
To learn more about FlexFunds and our ETPs, feel free to contact our team of experts. Weâll be happy to assist you!
Sources:
- https://www.pwc.com/gx/en/industries/financial-services/publications/etf-survey.html
- https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-funds-and-exchange-traded-4
- https://www.sec.gov/investor/alerts/ib_fees_expenses.pdf
