Getting an Edge With 'Fundamental Indices'

A new kind of fund is attracting the attention of investment experts, as well as billions of dollars of pension and private-investor monies. Sometimes referred to as "fundamental indices," these products have exceptional risk and reward characteristics.

To understand these new investments, let's take a brief look at the differences between a fund and an index.

An actively managed fund -- and there are many thousands of them -- is usually a bundle of, say, 25 to 50 stocks or bonds selected by professional asset managers on the basis of research, earnings, risk ratios and so forth. They are labor-intensive investment structures, they cost a lot to construct and manage, and they are the typical kind of product offered by the majority of 401(k) plans.

By comparison, an index is a bundle of stocks or bonds that attempts to replicate an entire market (or sometimes just a portion of one).

For example, when you put money in Vanguard's (VFINX Quote)500 Index, you are investing in a basket of all 500 stocks that compose the S&P 500's universe of shares. And those stocks are weighted in the index on the basis of their market capitalization, or market cap.

Market cap is simply the price per share of a stock multiplied by the number of shares outstanding. Suppose there are two companies, and each has 1,000 shares of stock outstanding. Company A's shares trade at $5 apiece, and Company B's shares trade at $2.50 apiece. A typical index weighted by market cap will buy and hold twice as many shares of Company A relative to Company B.

There are many different kinds of index funds, and they have several distinct advantages over actively managed funds.