ETF Index Structures: How Weighting Matters

February 7, 2013

Michael Iachini
CFA, CFP®, Managing Director of ETF Research, Charles Schwab Investment Advisory, Inc. 

As many investors know, most exchange-traded funds (ETFs) are investments that track indexes—baskets of securities like stocks or bonds. There's more than one way to build an index, though, and the way your stock ETF's index is built can have a big impact on your returns. Whether the securities in an index are weighted based on market capitalization, equal weighting, fundamentals or low-volatility can give ETFs very different characteristics.

Market capitalization weighting—a popular choice

The most common weighting scheme for indexes is to use market capitalization, sometimes referred to as cap weighting. A stock's market capitalization is the amount of money it would cost to buy all of the outstanding stock in that company. Put another way, it's the total value of the company as determined by the stock market. Indexes built on market capitalization give the most weight to companies that are deemed to be very valuable by the stock market and the least weight to companies that are deemed to be of low value by the market.

Examples of cap-weighted indexes include the S&P 500® Index, the Russell 3000® Index, the MSCI EAFE® Index and the Dow Jones US Total Stock Market Index^SM.

One advantage of an ETF tied to a cap-weighted index is that the ETF manager doesn't need to do much trading, which means that the ETF's trading expenses will be low and it will be less likely for the ETF to make taxable capital-gains distributions to shareholders at the end of the year. This is because the weights of the stocks in the ETF portfolio change as the market value of the stocks change, which is exactly how the index is changing. For this reason, cap-weighted index ETFs tend to have low operating expenses and good tax efficiency.

Some critics feel, however, that there's a potential disadvantage in market-cap weighting because it puts more weight on companies that might be most overvalued by the stock market and less weight on companies that are possibly undervalued.

Equal weighting—keeping it simple

If you're looking for simplicity, you can't get much simpler than equal weighting. An equal-weighted index of 100 stocks would have 1% of its assets in each stock. ETFs that track equal- weighted indexes can usually be identified by looking for "equal weight" in their names. Equal-weighted indexes are easy to understand and there's little risk of any single stock having an outsized impact on the returns of the index.

There are a few potential disadvantages to keep in mind with equal-weighted indexes, however:

• First, because different stocks will perform differently, a portfolio tracking an equal- weighted index will need to rebalance regularly, selling some shares of stocks that have performed well and buying shares of stocks that have performed poorly. This creates the potential for capital gains distributions and also adds to the operating costs of these portfolios.
• In addition, it's important to understand that equal-weighted index ETFs will have more of their assets in smaller companies than cap-weighted index ETFs. That means that a market in which smaller companies perform poorly will likely leave equal-weighted portfolios lagging behind cap-weighted portfolios.

Fundamental weighting—a better way to build an index?

There's been a trend in recent years of indexers trying to "build a better mousetrap" with their index construction. One approach that has gained some support is fundamental weighting. ETFs that follow fundamental indexes tend to have names containing the word "fundamental" or the terms "RAFI®" (from Research Affiliates, a company that produces fundamental indexes) or "AlphaDEX®" (another family of fundamental indexes).

Instead of weighting stocks by their stock market values, fundamental indexes weight by fundamental factors such as a company's profits, dividends, book value, cash flow, sales or number of employees. The rationale here is that these fundamental factors may correspond more closely to a company's "true" economic value.

The potential advantage of fundamental weighting is performance. If it's truly the case that cap weighting puts too much money into overvalued companies, fundamental-weighted indexes should perform better if the markets ultimately correct the imbalance.

On the downside, fundamental-weighted indexes require more trading than cap-weighted indexes, so there's a greater possibility of capital gains distributions. Operating expenses also tend to be significantly higher than for cap-weighted indexes. In addition, if the hypothesis behind fundamental weighting is incorrect, the performance of ETFs tied to fundamental indexes could be poor compared to traditional cap-weighted indexes.

Low-volatility weighting—a smoother ride?

In recent years, several ETFs have been launched based on low-volatility indexes. While the exact approach can vary from one index provider to the next, the general idea is to put together a portfolio of stocks whose ups and downs are expected to be smaller than the broader cap-weighted indexes. These ETFs typically have a reference to “low volatility” or “minimum volatility” in their names.

The potential advantage of low-volatility indexes comes mainly in down markets, where they have often provided more protection than cap-weighted indexes in the past. While these indexes still tend to drop in value in down markets, the size of the downturn for the low-volatility indexes has usually been smaller.

On the other hand, low-volatility indexes have historically not kept up with cap-weighted indexes in strongly rising markets. In addition, if the markets do well in the long-term without a lot of reversals, low-volatility indexes may not perform as well as cap-weighted indexes.

Other weighting schemes

There are a few other weighting schemes for index ETFs. For instance, with a price-weighted index the higher the share price of a stock, the greater its weight. This is a rather arbitrary methodology, since the share price depends on how many shares the company decides to issue.

Income-focused indexes may weight stocks based on the amount or growth rate of their dividends.

Quantitative or "dynamic" indexes give more weight to stocks with characteristics selected as attractive or predictive based on valuation and momentum.

"Factor" indexes aim to track market factors such as high beta or high momentum.

As new ETFs come to the market, they may launch with a specific "twist" on index weighting to make them stand out from an increasingly crowded pack. It's important to read the description of the ETF to understand how its index is built.

Which index is right for you?

If low cost and tax efficiency are your priorities consider sticking with traditional market-capitalization-weighted index ETFs. These are also the way to go if you believe in market efficiency—the idea that stock prices reflect all available information about the true values of companies.

For simplicity of understanding and a desire to not let any one stock have too much of an effect on your returns, equal weighting is hard to beat. Keep in mind that costs and turnover can be higher and that the fund will have more weight in smaller companies.

If you believe that a company's fundamentals are a better measure of its value than market capitalization, then consider a fundamental index. Approach these funds much as you would an actively managed mutual fund, evaluating whether the methodology has a good chance of doing better than the lower-cost index alternatives.

If you're concerned largely with downside protection and are willing to surrender some gains in rising markets, take a look at low-volatility indexes.

To give you an idea of how the four major weighting schemes compare for the biggest US stock ETFs, take a look the table below. Note that the expenses, turnover and performance can vary significantly across the various strategies.

Comparison: The Biggest US Large Company ETF for Each of the Major Weighting Schemes

Source: Morningstar Direct as of December 31, 2012. Past performance is no indication of future results.
* Low-volatility ETFs did not exist prior to 2011.