Do you prefer to own stocks in particular industries? Are you interested in funds that trade only in North American stocks?
Peter Lynch advises that there are many different types of index funds that track different segments of the financial market, depending on where an investor wants to put their money. He explains market cap funds, sector-based funds, and regional funds.
Keep reading to learn about these three types of index funds and see what might work best in your portfolio.
#1: Market Cap Index Funds
Market cap is a type of index fund that invests in stocks based on those stocks’ total market capitalization (or “market cap”)—the number of shares currently issued multiplied by the price per share. So, for example, a company with one million shares currently issued trading at $50 per share would have a market cap of $50 million. There are funds that invest in large-cap stocks (those with market caps above $10 billion), mid-cap stocks (with market caps between $2 billion and $10 billion), and small-cap stocks (those with market caps between $250 million and $2 billion).
You’d purchase shares in large-cap index funds if you want the relative stability of investing in mature, well-established companies that are more likely to earn steady returns than small companies or startups. On the other hand, you’d invest in medium- or small-cap index funds if you want the potentially high returns that can come from investing in startups and growing companies—and can stomach the higher volatility and risk that can come with it.
(Shortform note: Although you can invest in mid-cap and small-cap indexes if you want to cover the entire market, you can have most of the total market represented in your portfolio just by investing in large-cap funds. This is because the biggest stocks already account for such a large share of the total market capitalization. The S&P 500 index of large-cap US equities encompasses the top 500 American companies by market capitalization. According to S&P, this represents approximately 80% of the total market capitalization.)
#2: Sector-Based Index Funds
There are also index funds that buy stock in companies exclusively in a specific industry or market. For example, a fund may buy shares of companies in sectors like energy, consumer goods, health care, information technology, or real estate. You’d invest in a sector-based fund if you believe that that sector offers higher potential for growth than other sectors of the economy, or if you want to hedge your portfolio if you’ve invested in other sectors.
For example, let’s say you’ve invested heavily in the traditional energy sector (which includes oil companies, natural gas producers, and coal mine operators). You might then want to purchase shares in a renewable energy index fund (which includes companies engaged in wind, solar, hydroelectric, and even nuclear energy), so you can offset potential losses in case the price of oil drops or if the government passes new regulations that restrict fossil fuel production.
(Shortform note: Sector-based funds do come with their own unique risks. Investing in a sector-based index fund means your returns are closely tied to the performance of a specific industry, even if you’re diversified within that industry. If that sector experiences difficulties or downturns, your portfolio could take a hit. Cyclical effects could also put your portfolio at risk. This is because different sectors of the economy tend to perform differently at various points in the economic cycle. For instance, tech sectors might do well during economic expansions, while utility sectors might perform better during recessions. If you don’t watch these cyclical effects, you could wind up overly invested in a sector on the wrong end of the business cycle.)
#3: Regional Index Funds
There are also index funds that buy shares in companies (often those with the largest market caps across a wide range of industries) that are based in a particular region or country. So, for example, there are funds that trade exclusively in North American, European, Asian, or South American stocks.
You would invest in regional index funds if you believe that a particular region or country’s economy offers the kind of growth you want. If you want more stable, but potentially lower returns, you would perhaps invest in a regional fund that comprises companies from more developed markets, such as North America or Western Europe. If you’re looking for potentially high returns (and can handle higher risk), you might invest in regional index funds composed of stocks from companies in developing parts of the world—such as sub-Saharan Africa or Southeast Asia.
(Shortform note: When you invest in region- or country-specific index funds, it’s important to understand country risk. Country risk is the risk of investing in a particular country. The risk can come from factors including but not limited to political instability, natural disasters, and unfavorable exchange rates. There are several resources available to assess country risk, including information published by the Organisation for Economic Co-Operation and Development (OECD). In addition, the major credit rating agencies—Standard & Poor’s (S&P), Moody’s, and Fitch—each have country-by-country analyses of economic fundamentals such as political stability, the rule of law, and fiscal and monetary flexibility.)