3 Types of Indexing for ETF Success

Indexing is a strategy used in various investment products, including exchange-traded funds (ETFs). Three weighting methods are used for index ETFs: market-cap-weighted, equal-weighted, and fundamental indexes. Each indexing strategy has advantages and disadvantages while catering to different investment and risk management goals. Market-cap-weighted index ETFs are ordinarily more stable but focus on a few large companies. Equal-weighted and fundamental index ETFs are more diversified and have a greater potential for outperformance but typically have higher management fees and greater volatility.

Market-Cap-Weighted Indexing

Market-cap-weighted index ETFs, like those that track the S&P 500, weigh companies according to their market capitalization, giving greater influence to larger firms. While this approach is reflective of broader market conditions, it can be disproportionately affected by a few large companies.

How Does Market-Cap-Weighted Indexing Work?

A market-capitalization-weighted index weighs its component assets based on market capitalization. In simplest terms, the larger a company's market cap, the more its sway on the index's performance. Market capitalization is calculated by multiplying a company's stock price by the total number of outstanding shares.

Suppose we have a fictional index consisting of three companies: Company X with a market cap of $600 billion, Company Y with $400 billion, and Company Z with $200 billion. The total market cap of this index would be $600 billion. Company X would comprise 50% of the index, Company Y 33.33%, and Company Z 16.67%. Hence, any price changes in Company X's stock would significantly impact the index more than for Company Y and Company Z.

Investors ordinarily favor market-cap-weighted index ETFs for their stability and lower management fees. These index ETFs also provide a reliable reflection of market trends, given the influence of established, high-value companies. Nevertheless, these index ETFs can be too concentrated in certain sectors and lack diversification.

The Advantages and Disadvantages of Market-Cap-Weighted Index ETFs

Market-cap-weighted index ETFs have benefits and limitations:

Benefits:

• Market representation: This type of index ETF better reflects market conditions, as larger companies naturally have a greater market impact.
• Lower turnover: The need for rebalancing is less frequent than for other index ETF types, which can reduce transaction costs.
• Liquidity: Larger companies are generally more liquid, making buying or selling index ETFs based on market-cap-weighted indexes easier.

Limitations:

• Concentration risk: These index ETFs can be heavily influenced by a few large companies, which can introduce volatility and risk when firms face difficulties.
• Underrepresentation: Smaller companies are given only a slight role in these ETFs, which might mean missing out on the growth opportunities they can provide.
• Potential for market distortion: Overvalued companies could become even more overvalued in bull markets as their rising value increases their weight in these index ETFs.

Examples of Market-Cap-Weighted Index ETFs

Here are some market-cap-weighted indexes:

• S&P 500 (SPY): This ETF represents the top 500 large-cap U.S. stocks.
• MSCI ACWI: This ETF covers developed and emerging markets around the world.
• EURO STOXX 50: This ETF comprises 50 stocks from 11 countries within the eurozone.

Equal-Weighted Indexing

An equal-weighted index gives each constituent the same weight, whatever its market capitalization or other financial metrics. This approach delivers a balanced exposure to all companies in the index, making it less susceptible to the influence of a few large-cap securities.

How Do Equal-Weighted Indexes Work?

An equal-weighted index provides an equivalent weight to each component, regardless of market capitalization or other characteristics. Thus, each asset equally influences the index's overall performance. For example, suppose we have 100 companies in an equal-weighted index. Each would have a 1% weight, despite potentially having vastly different market caps.

To preserve this balance, equal-weighted indexes undergo periodic rebalancing, ordinarily quarterly or semiannual. During rebalancing, the portfolio is adjusted by selling assets that have gone up in value and buying those that have declined, ensuring that the components have equal weights.

The Advantages and Disadvantages of an Equal-Weighted Index ETFs

An equal-weighted index ETF offers advantages and disadvantages that cater to specific investment needs.

Benefits:

• Diversification: By giving equal weight to each stock, this type of index ETF offers balance across various sectors and company sizes. This avoids focusing on a few large-cap stocks, allowing the potential for outperformance from smaller stocks.
• Reduced concentration risk: Unlike market-cap-weighted indexes, equal-weighted indexes are less susceptible to volatility from a few large companies.
• Potential for higher returns: Smaller companies, which might be unable to have an impact in market-cap-weighted index ETFs, could offer higher growth potential.

Limitations:

• Higher costs: Habitual rebalancing is required to maintain equal weights, leading to higher transaction costs. Additionally, these index ETFs typically have more active management, which could result in higher fees.
• Volatility: These index ETFs can be more volatile as smaller companies tend to have higher market risk,
• Sector imbalance: If smaller companies dominate a particular sector, an equal-weighted index ETF may unintentionally overweigh that sector.

Examples of Equal-Weighted Index ETFs

Here are examples of equal-weighted index ETFs:

• Invesco S&P 500 Equal Weight (RSP): This is an equal-weighted ETF version of the S&P 500.
• Russell 1000 Equal Weight Index: This index ETF covers the largest 1,000 U.S. companies with equal weighting.
• Nasdaq-100 Equal Weighted Index: This is an equal-weighted ETF version of the Nasdaq 100 Index.

Fundamental Indexing

A fundamental index uses dividends, earnings, revenues, and other basic measures to weigh the constituent stocks rather than market capitalization. This approach focuses on a company's intrinsic value and financial stability.

How Do Fundamental Indexes Work?

A fundamental index weighs the constituent securities based on fundamental metrics rather than market capitalization. These metrics could include earnings, dividends, revenue, or book value. The idea is to focus on the intrinsic value of a company rather than its market value.

For example, an index could focus on a combination of dividends, earnings per share, and revenue to determine how to weigh each stock. Thus, if Company X is stronger in these fundamentals than Company Y, Company X will have a greater influence on the index. Periodic rebalancing is needed to keep the index aligned with its chosen metrics. This is usually done quarterly, semiannually, or annually, so the index reflects the most recent data. During rebalancing, stocks that have improved their fundamentals may be given greater weight, while those whose fundamentals have declined may have their weight reduced.

The Advantages and Disadvantages of a Fundamental Index ETFs

A fundamental index ETF offers unique advantages and challenges.

Benefits:

• Focus on intrinsic value: By weighing stocks based on fundamental metrics, these index ETFs aim to profit from the intrinsic value of companies, potentially delivering more stable returns.
• Reduced volatility: These index ETFs may deliver less volatility than market-cap-weighted index ETFs since they are less influenced by market sentiment.
• Value orientation: These index ETFs are typically tilted toward value stocks, which can offer an advantageous ratio between risks and rewards.

Limitations:

• Potential underperformance in bull markets: These index ETFs could lag behind market-cap-weighted index ETFs during strong markets. Like any other index ETF, there is no guarantee that simply focusing on fundamentals will yield better returns, especially during periods when growth stocks outperform value stocks.
• Complexity: Using several fundamental metrics can make these index ETFs more difficult to understand and analyze.
• Higher costs: Frequent rebalancing to update fundamental data could lead to higher transaction costs and management fees.

Examples of Fundamental Indexes ETFs

Here are some examples of fundamental index ETFs:

• RAFI Fundamental Index: Developed by Research Affiliates, this index ETF uses a combination of four fundamental measures: book value, cash flow, sales, and dividends.
• Schwab Fundamental U.S. Large Company Index: This ETF uses adjusted sales, retained operating cash flow, and dividends plus buybacks for weighting.
• FTSE RAFI US 1000 Index: This ETF uses four fundamental factors: dividends, cash flow, sales, and book value.
  

Evaluating ETF Performance

ETF performance is usually assessed according to metrics like capital gains, dividends, expense ratios, and overall net asset value.

Investors need to examine an ETF's historical and current performance, composition, and risk-adjusted returns to make an informed investment decision. You should also evaluate its tracking error, which measures how closely the fund reflects its benchmark index. A lower tracking error can signal a better alignment with the index and, thus, better performance. In addition, expense ratios can greatly affect net returns and should be reviewed closely before investing in an ETF.

We can see some of these measures below. The table lists the general characteristics of the three types of index ETFs mentioned above: SPY (Market Capitalized), RSP (Equal Weighted), and FNDX (Fundamental Index).

This table looks at the same ETFs by listing its top-10 holdings.

This table lists the one-year, three-year, five-year, and 10-year annualized returns of SPY, RSP, and FNDX.

The Bottom Line

The choice among market-cap-weighted, equal-weighted, and fundamental index ETFs depends on your strategy and risk tolerance. Market-cap-weighted index ETFs like the S&P 500 reflect market sentiment but can be skewed by large companies. Alternatively, equal-weighted index ETFs provide a balanced exposure to all companies in the index, albeit at the cost of higher transaction fees because of frequent rebalancing. Fundamental index ETFs focus on measures of intrinsic value such as dividends, revenue, and earnings, offering the potential for more stable performance. These index ETFs, however, may underperform in strong bull markets.

Understanding the nuances of these indexes is crucial for portfolio construction and investment success. While market-cap-weighted index ETFs are popular for their broad market representation, equal-weighted and fundamental index ETFs offer alternative approaches based on balanced exposure and intrinsic value, respectively. Each serves different investment goals.