| Featured Author: Carmine D’Avino, CFP |
Do Your ETF’s Really Align With Your Objectives?
overview of the most popular weighting methodologies for index ETFs
Growing Appetite For Index-based Investments
Ever since the first exchange traded fund (ETF) was launched in 1993, there has been a growing interest in index-based strategies from both individual and institutional investors. ETFs are “baskets” of securities which aim to track a market index. These securities combine the benefits of traditional index mutual funds – diversification, low costs and tax efficiency – with the trading flexibility of individual stocks.
As an investment advisor who has utilized ETFs for years, I have watched the industry grow tremendously and with it the variety of investable indexes. There are currently over 1,200 different ETFs with assets of approximately $1.2 trillion. Today you can find an index that tracks everything from the entire U.S. bond market to one just comprised of companies in the lithium industry.
Although we now have numerous indexes that track just about anything, there are still only a few primary ways to construct them. Hopefully, having an understanding of these different methods will help you better comprehend and follow your investments. Here’s an overview of the most popular weighting methodologies for indexes and some characteristics of each.
Market-cap weighting is by far the most popular approach to index construction and the S&P 500 is the most prominent index used. In cap weighted indexes, the amount of each component in the index is proportionate to its market value, or capitalization. (The market cap of a security is determined by multiplying the share price by the number of shares outstanding.) The weighting of each component automatically adjusts with changes in market price and shares outstanding.
Market-cap weighted indexes have many practical characteristics that appeal to passive investors. Namely, they provide broad market representation through an objective and transparent methodology. In addition, cap-weighted indexes do not require frequent rebalancing which helps to keep costs low for funds that replicate them.
A criticism of cap-weighting is that greater emphasis is placed on the biggest companies and that the contribution of smaller, potentially undervalued or faster growing securities can be minimal.
Example of a market-cap weighted index ETF: SPDR S&P 500 SPY *
In a price-weighted index the components are simply weighted by their price per share. Stocks with a higher price are given more weight and consequently have a greater influence on the performance of the index. This methodology ignores other factors like the number of shares outstanding and market capitalization. The Dow Jones Industrial Average (DJIA) is a well known index that reflects a price-weighted average of 30 U.S. blue chip stocks. For more on the topic of price-weighted indexes and the DJIA in particular, check out this recent Barron’s article → Shake Up The Dow!
Example of a price-weighted index ETF: SPDR Dow Jones Industrial Average DIA *
In equal-weighted indexes each component is held in equal proportion, regardless of market cap. While market-cap weighted indexes provide broad diversification through exposure to every security in the index, equal-weighting provides equal exposure to every company in the index. For example, an equal weighted S&P 500 fund still includes the same 500 stocks as the cap-weighted version, but in equal amounts. Equal-weighted indexes provide a greater bias to mid and small sized companies, which sometimes offer better returns than the largest companies.
These indexes and the funds that replicate them must be re-balanced periodically to maintain equally weighted positions. This creates transaction costs and as such these funds generally have higher expense ratios than cap-weighted index funds.
Example of a equal-weighted index ETF: Rydex S&P Equal Weight ETF (RSP) *
Fundamental indexes weight their components based on a fundamental metric or combination of metrics such as dividend yield, earnings, book value and cash flow.
To passive investment purists this method of index construction blurs the line between active and passive management and does not serve as a proxy for the market. Proponents of this approach believe that market capitalization alone cannot reliably represent the underlying value of a company and that weighting based on fundamentals is a better “mousetrap”. This is a debate I am sure will carry on for years to come.
What is fairly conclusive is that fundamental indexes are effective at providing a tilt or bias within a portfolio. For example, an index that weights its components by dividend yield will have a greater income focus. Additionally, studies have demonstrated that many fundamental equity indexes tend to have a tilt towards value and small cap stocks.
Funds that employ this methodology tend to be more expensive than other index funds. These rules-based indexes require periodic rebalancing which adds to transaction costs and results in higher expense ratios.
Example of a fundamental index ETF: WisdomTree Total Fund (DTD) *
Be Mindful of Your ETF Weight
The weighting methodology of an index has a major influence on its risk/return profile. Ultimately, what is most important is that you understand how any index you invest in is constructed and that its characteristics are aligned with your objectives.
*The exchange traded funds (ETFs) listed in this article are for informational purposes only and are NOT investment recommendations.
Due to various factors, including changing market conditions and/or applicable laws, the presented material(s) may no longer be reflective of current opinions or positions. The thoughts and opinions expressed in the presented material(s) relate only to the author and are not necessarily reflective of PWM’s views. Moreover, you should not assume that any discussion or information contained in the presented material(s) serves as the receipt of, or as a substitute for, personalized investment advice from PWM. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Photo Credit: puuikibeach – flickr
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