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Investors own index funds for a simple reason: They don't want to pick individual stocks. They'd rather hold a broad basket of stocks that doesn't give preference to any one company.

For those who don't have the time or inclination to dive into individual stocks, index funds are the way to go. Warren Buffett even said as much many years ago: "Most investors ... will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results ... delivered by the great majority of investment professionals."

Some might be surprised to learn, however, that most index funds aren't as passive as they might think.

The most popular index, the S&P 500, consists of (redundantly) 500 large- and mid-cap stocks from dozens of different industries.

But because of how the index is set up, owning it through a low-cost ETF like the SPDR S&P 500 (NYSE: SPY  ) doesn't give you an equal share in 500 companies. Rather, the index is sliced by market capitalization so that the largest companies hold the largest weight. It's like the electoral college system of investing.

The impact this has on the index is enormous. In the SPDR 500 fund, the top five companies -- ExxonMobil (NYSE: XOM  ) , Apple (Nasdaq: AAPL  ) , Chevron (NYSE: CVX  ) , General Electric (NYSE: GE  ) , and IBM (NYSE: IBM  ) -- currently make up more than 11% of the index. The bottom five make up less than 0.05%. The top 100 companies represent 65% of the index, while the bottom 100 account for just 3.4%. Exxon alone currently has a higher weighting than the bottom 100 companies, and the top 10 companies have about the same weighting as the bottom 250. Think about these numbers, and it's almost disingenuous to call it a 500-company index. It's more of a 200-company index with some negligible scraps of another 300 companies thrown in.

How this affects returns should be obvious: The index leans heavily toward the largest companies of the 500 it follows, with almost no focus on the smaller end.

This can create some unfortunate skewing. Take the case of Cisco (Nasdaq: CSCO  ) . The company's value went parabolic in the late 1990s. By 2000, Cisco had a market cap of around $500 billion, capturing about 4% of the S&P 500 index.

Problem was, Cisco's size wasn't indicative of its success. It was entirely a product of the dot-com bubble. The same was true at the time for other massive companies like the former AOL Time Warner conglomerate. By the time the bubble burst, the S&P 500's weightings made it skewed toward some of the market's most overvalued stocks, dragging down subsequent returns more than should have been necessary. As my colleague Matt Koppenheffer has shown, larger companies underperformed -- rather dramatically -- smaller ones over the past decade. The S&P's weightings caused it to hold infinitesimally small amounts of the best-performing stocks, while being overweight the overvalued laggards.

In a way, this isn't a problem. The point of an index is to knowingly hold some good stocks, some bad ones, and a mix of mediocre ones. Any group of stocks will outperform from time to time. Criticizing the index for holding too much or too little of that group misses the point of indexing.

But there's a larger point that indexes like the S&P 500 don't do a very good job at, well, indexing. By weighting companies by market cap, the index favors one company over another -- exactly what those buying index funds seek to avoid.

There could be better ways to go about indexing. One is to equal weight each holding. Some index funds track the same holdings as the capitalization-weighted S&P 500, but rebalance periodically so that every company holds the same 1/500 weighting. This is, I think, how most investors assume index funds work -- you own a diverse basket of 500 stocks without giving favor to industry or company. In 2008, Standard & Poor's, the company behind the S&P 500 index, issued a report comparing the equal-weight index to the traditional market-weighted index. While the results were anything but consistent year to year, the equal-weight index outperformed by 1.5% per year over the last 20 years, albeit with slightly higher volatility.

Another way to index is to first ask the question: If an index is going to select for a certain quality, why make it size? Why not value? There's a growing trend in so-called fundamental indexing. These funds hold hundreds, if not thousands, of stocks, and periodically rebalance so the cheapest companies based on metrics like price-to-earnings or price-to-book hold the highest weightings. The early results have been impressive. Over the past decade, a fundamental index fund pioneered by Rob Arnott of Research Affiliates returned 5.3% per year, compared with about 1% annually for the capitalization-weighted S&P 500. Renowned investor Joel Greenblatt also just launched a family of fundamental index funds. Back-testing the funds' methodology over the past 20 years, Greenblatt's fundamental index outperformed "by about 6% a year and it had the same volatility and the same beta as market cap-weighted index."

Some protest that these funds should be labeled as actively managed, rather than indexes. But there's a key difference between the two. In fundamental indexing, stock selection is formulaic. In active management, it's subjective. More importantly, the capitalization-weighted S&P 500 index is itself formulaic. Fundamental indexing simply uses what history shows is a more rational set of formulaic criteria -- value instead of size.

All index fund investors seek diversity. The question is what you do from there. If you're looking for a fund weighted toward the largest companies, the traditional S&P 500 is for you. If you want the most diverse basket of stocks, an equal-weighted index might be more appropriate. If you're of a value-investor mind-set, some of the new fundamental index funds might be up your alley. The point is that investors looking to track a broad group of stocks don't have to limit their options to the S&P 500. A better index often exists.  

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel owns shares of SPY and ExxonMobil. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of International Business Machines and Apple. Motley Fool newsletter services have recommended buying shares of Chevron and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (7) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 07, 2011, at 5:10 PM, TMFAleph1 wrote:

    Nice article, Morgan, but I have one quibble:

    <<In fundamental indexing, stock selection is formulaic. In active management, it's subjective. More importantly, the capitalization-weighted S&P 500 index is itself formulaic. Fundamental indexing simply uses what history shows is a more rational set of formulaic criteria -- value instead of size.>>

    Not sure I agree with you here. There are plenty of quantitative managers who select stocks based on systematic rules such that there is no subjective input from the fund managers.

    The market cap-weighted index isn't just one "formulaic" index among many, it corresponds to the "market portfolio", which represents the average performance of all investors (before costs and fees) -- that concept is of fundamental theoretical importance in Finance. The same can't be said of a fundamentally-weighted index.

  • Report this Comment On June 08, 2011, at 7:49 AM, dbtheonly wrote:

    What's the difference between an "actively managed" index fund and a more traditional mutual fund?

    And for that matter, what's wrong with buying X number of shares in each of the S&P 500? Why weight by size at all?

  • Report this Comment On June 08, 2011, at 10:33 AM, TheDumbMoney wrote:

    I have multiple problems:

    1) Greenblatt's funds might be more attractive if their expense rations didn't range from 1.25% to 2.01%. That is not the fee range of an index fund, it's the fee range of an actively-managed fund, and not particularly compelling.

    2) More "fundamentally," you appear to set up Greenblatt's system as an antidote to the S&P's higher weighting of higher market-cap stocks. But that's not true. Greenblatt's system gives higher weight based on fundamental factors (price to certain measures of intrinsic value) to various stocks. Thus, it ALSO "favors one company over another -- exactly what those buying index funds seek to avoid."

    That is of course why the fee is higher than an index-fund fee. It's an active fund in the sense that it does depend upon investment-manager expertise in selecting, in the first place, which stocks have the largest discounts to various measures of value. Really, then, it's what every single darn fund manager in the world tries to do! (Pick stocks that are undervalued.) But with even more stocks than the average mutual fund has, while pretending to add value while in actuality approaching an indexed result! Seriously, we ding mutual funds for trying to "beat" the S&P by "picking" stocks and ending up with 129 of them. How on earth is this any different, except that it adds a veneer of rigidity to that fundamental structure?? Am I smoking somethign? I seriously just don't get it.

    In reality, if you want the opposite of what the S&P 500 index does, then you want an index whereby the largest 500 companies are purchased by rote, in EQUAL amounts, and the index is constantly rebalanced to maintain that, period. I haven't spent a bunch of time thinking about it, but I think that would have the effect that you are constantlly selling your winners and buying your losers, which might or might not be good. I happen to think it would be good, at least as a part of a portfolio: it would have the effect, for example, that you would have failed to receive the benefits of Cisco's huge late-nineties run-up, but also failed to receive the sh!tslap of Cisco's 2000's performance. It seems to me, again without really thinking this through, that the S&P indexes, as currently weighted, gives some sort of a premium to stock-momentum, which if true is something that I at least pretty much never like.

    But Greenblatt's funds it seems to me are really just incredibly non-concentrated mutual funds masquerading as index funds, and poorly, because they don't have index-fund fees.

  • Report this Comment On June 08, 2011, at 10:34 AM, TheDumbMoney wrote:

    @dbtheonly: looks like you beat me to my points, but much more concisely. Well-played.

  • Report this Comment On June 08, 2011, at 10:40 AM, cmfhousel wrote:


    <<Thus, it ALSO "favors one company over another -- exactly what those buying index funds seek to avoid.">>

    That Greenblatt's funds also select was acknowledged in the article: "Another way to index is to first ask the question: If an index is going to select for a certain quality, why make it size? Why not value?"

    And while Greenblatt's funds do indeed have fairly high fees, Arnott's fundamental index funds charge 0.39% -- still higher than SPY, but far lower than most active funds.

  • Report this Comment On June 08, 2011, at 10:53 AM, TheDumbMoney wrote:

    I did not mean to imply you did not acknowledge it, so I apologize. It's that by talking so about what the S&P does versus what the expectations of most investors are, you also implicitly in my view set this up as in opposition to the idea that most investors think they are getting an equal share of each company. Really the fact that most investors expect equal weights of each company is irrelevant to the distinction between Greenblatt/Arnott and the S&P index as currently weighted. But maybe that's just how I read it, it is early for me in California after all, and I haven't had my coffee yet.

  • Report this Comment On June 08, 2011, at 11:40 AM, BxBruce007 wrote:

    Did I miss something or did you write an entire article about alternative index funds and then didn't mention any. Well, you mentioned one family of funds and another in your response above, but no real alternatives to SPY, which, btw, MF has been recommending forever.

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