The *SEC's Office of Investor Education and Advocacy is issuing this Investor Bulletin to inform investors about features and potential risks of non-traditional index funds.

What are non-traditional index funds?

Some index mutual funds and exchange-traded funds (ETFs) use more complex or targeted investing strategies than have been traditionally associated with index funds. Unlike traditional index funds, which track a market index, these funds use custom-built indexes to select the fund's investments. By tracking a custom-built index, a non-traditional index fund may seek to achieve performance greater than a particular market or sector. Or, such a fund may seek exposure to securities based on factors like financial strength, or environmental, social and governance concerns.

The custom-built indexes are constructed using criteria that a manager might consider when actively managing investments in a fund. But non-traditional index funds are still "passively managed." The investment adviser seeks to track an index, rather than using its own independent judgment to manage the fund's investments.

What are some examples of non-traditional index funds?

Non-traditional index funds do not always fall into distinct categories. Here are some examples:

• Smart Beta – The custom-built indexes for these funds often use "factors" to select the fund's investments. A factor is a characteristic or feature that is believed to cause certain types of securities to outperform or underperform the market as a whole. Examples of common factors are value, dividends or quality.
• Quant Funds – The custom-built indexes for these funds use numerical methods like quantitative analysis or algorithms to select the fund's investments.
• Environmental, Social and Governance (ESG) Funds –The custom-built indexes for these funds use environmental, social and governance factors to select the fund's investments. These factors are subjective and could include concerns like avoiding the use of toxic chemicals (environmental), using certain approaches to executive compensation (governance), or achieving diversity on the Board (social). ESG investing is sometimes referred to as socially responsible investing.

How are these funds different from traditional index funds?

Non-traditional index funds have unique characteristics and risks. In some cases, they may be complex and difficult to understand. Take time to make sure a fund is a good fit for you by considering such things as: 

• Correlation to market. These funds may behave very differently than the market and traditional index funds. Because non-traditional index funds may be less correlated to the market, you may want to consider investing in them together with other types of funds. Depending on their characteristics, the other funds may help smooth out volatility and decrease risk. 
• Returns. These funds may have some features of active management, including seeking to outperform the market. But, these funds will not necessarily outperform the market or even perform comparably to the market. In addition, these funds may have limited performance histories. It may not be clear how they will perform under different market conditions.
• Diversification. These funds can be used to help create a diversified portfolio. But, to ensure a fund adds diversity to your portfolio, you should understand how the index was constructed. In addition, look through the index to the actual holdings of the fund. Different indexes may include the same securities. Or, indexes could give more weight to certain securities than you might expect. Make sure your investments are as diversified as you think they are.
• Complexity. These products may be difficult to understand because their methods for attempting to achieve returns may not be straightforward. For example, an index based on quantitative analysis or algorithms may involve complicated mathematical calculations and economic concepts.
• Cost. These funds may be less expensive than actively managed funds because managers are not actively picking securities, so they do not need the services of research analysts and others that help pick securities. But, these funds typically have higher expenses than traditional index funds. Always be sure you understand the actual cost of any fund before investing.

Before You Invest

Before investing in any fund, you should carefully read all of the fund's available information. This information includes the fund's prospectus and most recent shareholder report. In addition, funds disclose their portfolio holdings quarterly in Form N-Q and shareholder reports. You can typically get this information from the fund's website or your financial professional, as well as on EDGAR.

In addition, consider asking the following questions before investing in a particular index fund:

1. What fees and expenses can I expect to pay for buying, owning, and selling this fund?
2. What specific risks are associated with this fund?
3. How is the makeup of the fund's index determined? What are the actual holdings of the fund? 
4. How does the fund's investment strategy fit with my investment goals?

The *SEC's Office of Investor Education and Advocacy is issuing this Investor Bulletin to provide investors basic information about index funds.

An "index fund" is a type of mutual fund or exchange-traded fund that seeks to track the returns of a market index. The S&P 500 Index, the Russell 2000 Index, and the Wilshire 5000 Total Market Index are just a few examples of market indexes that index funds may seek to track.

A market index measures the performance of a "basket" of securities (like stocks or bonds), which is meant to represent a sector of a stock market, or of an economy. You cannot invest directly in a market index, but because index funds track a market index they provide an indirect investment option. 

What is in an index fund?

Index funds may take different approaches to track a market index:  some invest in all of the securities included in a market index, while others invest in only a sample of the securities included in a market index.  

Market indexes often use a company's market capitalization to decide how much weight that security will have in the index. Market capitalization (or "market cap") is a measure of the total value of the company's shares. The total value is equal to the share price times the number of shares outstanding. In a market-cap-weighted index, securities with a higher market capitalization value account for a greater share of the overall value of the index. Some market indexes, such as the Dow Jones Industrial Average, are "price-weighted." In this case, the price per share will determine the weight of a security.

Some index funds may also use derivatives (like options or futures) to help achieve their investment objective.

How do index funds invest?

Index funds have generally followed a passive, rather than active, style of investing. This means they aim to maximize returns over the long run by not buying and selling securities very often. In contrast, an actively managed fund often seeks to outperform a market (usually measured by some kind of index) by doing more frequent purchases and sales.

What are the costs associated with index funds?

Because index funds generally use a passive investing strategy, they may be able to save costs. For example, managers of an index fund are not actively picking securities, so they do not need the services of research analysts and others that help pick securities. This reduction in the cost of fund management could mean lower overall costs to shareholders. However, keep in mind that not all index funds have lower costs than actively managed funds. Always be sure you understand the actual cost of any fund before investing.

What are some risks of index funds?

Like any investment, index funds involve risk. An index fund will be subject to the same general risks as the securities in the index it tracks. The fund may also be subject to certain other risks, such as:

• Lack of Flexibility. An index fund may have less flexibility than a non-index fund to react to price declines in the securities in the index.
• Tracking Error. An index fund may not perfectly track its index. For example, a fund may only invest in a sampling of the securities in the market index, in which case the fund's performance may be less likely to match the index.
• Underperformance. An index fund may underperform its index because of fees and expenses, trading costs, and tracking error.

Before You Invest

Before investing in any fund, you should carefully read all of the fund's available information. This includes the fund's prospectus and most recent shareholder report. In addition, funds disclose their portfolio holdings quarterly in Form N-Q and shareholder reports. You can typically get this information from the fund's website or your financial professional, as well as on EDGAR.

Asking the following questions might help:

1. What fees and expenses can I expect to pay for buying, owning, and selling this fund?
2. What specific risks are associated with this fund?
3. How is the makeup of the fund's index determined?
4. How does the fund's investment strategy fit with my investment goals?

*Source and Updates: Investor.gov, U.S. Securities and Exchange Commission (SEC).