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Should you invest in index funds?

Traders work on the floor of the New York Stock Exchange during mid-day trading in New York City.

TEXT OF INTERVIEW

Tess Vigeland: How many times on this program do you think we've talked about index funds?

Chris Farrell: The low cost index fund movement revolutionized investing for ordinary folks, and for the better.

Jane Bryant Quinn: Buy mutual funds and furthermore buy index mutual funds that follow the market as a whole.

Lots of times. Too many to count. Mostly in the service of reminding you that index funds are safer than individual stocks. But index funds are a broad category of investing. And getting broader. This week, the Wall Street Journal profiled something called "alternative" indexes. Good excuse to for us to spend a little time on Wall Street this hour.

Josh Brown is an investment adviser at Fusion Analytics in New York, and I asked him to start by giving us a sense of how diverse the market is for index funds.

Josh Brown: Well you have your traditional indexes to start, which most people are familiar with. The S&P 500 can be accessed a variety of ways. Most people use the spider funds, SPY. You've also got the same thing for the Dow, for the Nasdaq, and in recent years, we've seen index funds launch for virtually every market around the world. Now we're seeing a whole new crop of index funds which are indexes, but they are created to capture different aspects of stocks.

Vigeland: Right. That's why we really wanted to talk to you, because I saw this article in the Wall Street Journal about "alternatively weighted indexes." So let's talk first about how the traditional indexes are weighted. Explain that for us.

Brown: So there are two types of traditional index weightings. The first, and most well-known, would be the Dow Jones, which is a price-weighted index. What that means is, the higher the price of the stock, the more weight it carries when they calculate the index. So in other words, IBM is the highest-priced stock in the Dow -- it's over $100 a share -- so as a result, it carries the most import on the Dow Jones index's daily fluctuation. The other type is the way the S&P is done, which is a cap-weighted, or market cap-weighted index. Companies like Exxon Mobil and Microsoft, which have the biggest market caps, tend to have the most weight in terms of what the S&P has done in a given day, week or month.

Now, you're seeing new products roll out, where they're saying OK, instead of an S&P 500 that's cap-weighted, what if we took all 500 stocks and we weighted them equally 0.2 percent? So 500 stocks have a weighting of, an equal amount for each stock. That way we capture a little bit more of a flavor of what the entire stock market has done, as opposed to having the top 10 companies dominate the performance.

Vigeland: That's really interesting because I think when a lot of your average investors think about the S&P 500, they actually think that you're just getting a big bucket of 500 of the biggest stocks that are out there in the marketplace, and I don't know if folks really understand that there's a weighting that goes on there.

Brown: Yeah Tess, if you look at the Nasdaq 100, and this is a really exacerbated example of what can happen in terms of companies growing so large that they skew the index: Apple Computer right now is a 20 percent weighting within the Nasdaq 100. Just purely by virtue of the fact that a lot of Nasdaq companies like Cisco and Microsoft have done nothing over 10 years, whereas Apple has gone up and up and up and up to the point where it is a fifth of the Nasdaq 100. So when people think they're buying the Nasdaq, you know, they are getting some exposure--

Vigeland: They're really buying a lot of Apple.

Brown: They're getting a lot of Apple. Now, that's been a good thing over the last five years, as Apple has launched product after product, and has continually climbed higher. But do you necessarily want to have an index fund that's 20 percent weighted toward Apple, if heaven forbid, they happen to stumble on a new product launch?

Vigeland: So for those folks who perhaps might be interested in doing this and say an IRA or brokerage account, how do they know if this is something that they want to do?

Brown: For IRA accounts or just regular brokerage accounts, I think with these types of products that are so new, that the average investor should probably allow for them to trade for a few quarters before they jump on. The reason why I say that is, you always have these concerns with index products and with any ETF, frankly, of what's called "tracking error." In other words, yes, this is what we believe the product will do, we're rolling it out with intention to track the equal-weighted S&P 500, but we really don't know until there's some trading history whether or not it'll accomplish that.

Vigeland: All right. Josh Brown of Fusion Analytics. Great explainer, thanks so much for helping us out.

Brown: I hope I was helpful, thanks for having me on.

Vigeland: By the way, you can find Josh on Twitter at @ReformedBroker; I highly recommend you follow him. And while you're at it, follow me at @radiotess.

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