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An index tracking fund is a fund that buys direct stocks with a view to directly matching a particular index (e.g. the S&P500 or Russell 2000).

One way to allocate assets in such a fund is to weight the share value held by the fund by the market capitalization of the companies that make up the fund.

This link explains how such a capitalization-weighted approach seems to be "buy high - sell low" because a company with a growing market cap. (increasing share price) will be bought, while one with a shrinking market cap. will be sold. This effectively means the fund will buy when the stock is high and sell when it is low (relative to the other stocks in the index).

How do I determine whether a given index tracker is avoiding (or using) this approach?

A suggested other approach is an equal-weight approach where the value of the shares held of each company in the fund is equal.

I suspect that I need to look at "asset allocation" or something like it, but I'm not sure what it is.

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up vote 8 down vote accepted

In a cap-weighted fund, the fund itself isn't buying or selling at all (except to support redemptions or purchases of the fund). As the value of a stock in the index goes up, then its value in the fund goes up naturally. This is the advantage of a cap-weighted fund, that it doesn't have to trade (buy and sell), it just sits on the stocks. That makes a cap-weighted fund inexpensive (low trading costs) and tax-efficient (doesn't trigger capital gains due to sales).

The buying high and selling low referred to by "fundamental indexation" advocates like Wisdom Tree is buying high and selling low on the part of the investor. That is, when you purchase the market-cap-weighted fund, at that time that you purchase, you will spend more on the higher-priced stocks, just because they account for more of the value of the fund, and less money goes to the cheaper stocks which account for less of the value of the fund.

In the prospectus for a fund they should tell you which index they use, and if the prospectus doesn't describe the weighting of the index, you could do a web search for the index name and find out how that index is constructed. A market-cap-weighted fund is the standard kind of weighting which is what you get if you buy the stocks in the index and then hold them without buying or selling.

Most of the famous indexes (e.g. S&P500) are cap-weighted, with the notable exception of the Dow Jones Industrial Average which is "price-weighted" http://en.wikipedia.org/wiki/Price-weighted_index. Price-weighting is just an archaic tradition, not something one would use for a new index design today.

A fund weighted by "fundamentals" or equal-weighted, rather than cap-weighted, is effectively doing a kind of rebalancing, selling what's gone up to buy more of what's gone down. Rather than buying an exotic fund, you could get a similar effect by buying a balanced fund (one that mixes stocks and bonds). Then when stocks go up, your fund would sell them and buy bonds, and the fund would sell the most of the highest-market-cap stocks that make up more of the index. And vice versa of course.

But the fundamental-weighted funds are fine, the more important considerations include your stocks vs. bonds percentages (asset allocation) and whether you make irrational trades instead of sticking to a plan.

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Thanks for the thoughtful answer! +1 I see what you mean: if you've already a holding in a rising (falling) share, then the rise (fall) means your capitalization rises (falls) with it. –  Peter K. Jun 7 '11 at 18:57
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There are some index funds out there like this - generally they are called "equal weight" funds. For example, the Rydex S&P Equal-Weight ETF. Rydex also has several other equal weight sector funds

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Thanks for the links! Good to know they can be called "equal weight". +1. –  Peter K. Jun 7 '11 at 18:58
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