Weighing reasons for index fund buys

Written by Gary Silverman, CFP®

You may remember (even if I don’t) a discussion in this column a while back about capitalization versus equal-weighted index funds. Most index funds, whether in the old-fashioned open-ended type of mutual fund or the newer exchange-traded fund (ETF) are capitalization weighted (also called cap-weighted). That means when the fund folks are figuring out how much of a particular stock to hold in a portfolio, they put more of a big company’s stock in the index and less of the small company. An equal-weighted index, as the name implies, puts equal values of each company in the index, no matter the company’s size.

While I tend to prefer equal-weighted index funds (primary because they tend to do better), there are very good arguments for using cap-weighted funds, at least when we are talking about stocks. Bigger companies, after all, represent more of a sector’s business and more of the general economy. If you are trying to build your portfolio to mimic the current economic average, then cap-weighting is for you.

There are more than just stock index funds—bonds are also available in index fund form. And, like stocks, they are usually capitalization weighted. But in the case of bonds, they don’t have more bonds from a company that is big and fewer bonds from a company that is small. They weigh them instead by the overall value of bonds issued by that company. Thus they’ll have more bonds from companies that borrow a lot and fewer bonds from companies that borrow very little.

I can think of no reason to buy more bonds just because a company borrows a lot of money. I might be willing to consider the size of a company, how many sales they made last year, or by the relative size of its cash flow. But to buy more because they have a lot of debt? Sounds kinda crazy to me.

If you agree with me, what do you do? First, you could forget about indexing and go with an actively managed bond mutual fund. I know that the financial media is all gaga about everything being indexed, but I personally like to see most of my bond holdings chosen by a real live human.

For those of you who have your hearts set on indexed bond funds, there are more and more “fundamental” bond index funds coming out. Fundamental means that they weigh on some factor or factors other than just how much debt is outstanding. For instance PowerShares (an example, not a recommendation) has a fund that, according to its prospectus, is  “… based on an issuer’s ability to service debt; specifically, the methodology utilizes four fundamental measures of firm size, including book value, sales, dividends, and cash flow.”

So just don’t buy an index fund because you hear you should buy an index fund. Buy one because you’ve decided that the way the index is constructed makes sense in general, and, more specifically, that it makes sense for you.

This article was published in the Times Record News "Your Money" column on July 12, 2015.