What Is an Index Fund? – Forbes Advisor Australia

As noted 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 piece of the company. With an index fund, the pool of money is used to purchase a portfolio of assets that duplicate the actions of a target index. Dividends, interest and capital gains are paid out to investors regularly.

The fund manager adjusts the share of the assets in their portfolio to match the index. By doing so, the return on the fund should match the performance of the target index, before accounting for fund expenses.

Why Index Weighting Matters for Index Funds

Indexes use different weighting strategies to track their underlying assets, and the choice can have a big impact on how an index fund performs. A price-weighted index takes into account each asset’s market price: Higher-priced assets have a bigger share in the index than lower-priced 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 weighting in the index.

Meanwhile, a market-cap weighted index considers each asset’s market capitalisation—the total money invested in the asset, or the so-called market cap—to determine its share in the index. The ASX 200 is a market-cap weighted index: Each component company’s market capitalisation determines its weighting in the index.

Why does this matter? A fund that tracks a price-weighted index needs to adjust its portfolio holdings more frequently, as market prices fluctuate, to keep up with its target index. With a market-cap weighting, there is less need for buying and selling to keep the fund aligned with its target. However, large-cap assets can have an outsized impact on the performance of both the index and any fund based on it.

An equal-weight index gives the same weighting in its calculation to each asset it tracks, independent of its price or market cap, large or small. For an index fund, that…

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