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The Difference Between ETF Indexes

The Difference Between ETF Indexes

Key Points
  • Index providers try to pick securities that represent the market or a slice of the market. Indexes with similar goals tend to have similar performance. 

  • Find out what to consider if an ETF changes its underlying index.

  • Differences in cost can be more predictable than differences in index performance.

As the number of ETFs (exchange-traded funds) continues to grow, the choices can be overwhelming. In certain widely used categories, such as US large-cap equity, you can find ETFs tracking indexes from many different providers.

In many respects, traditional index providers are trying to do the same thing by providing lists of stocks that do a good job of representing a particular market or slice of a market. The general approach tends to be the same, but the details differ.

So what are the differences between the indexes behind these ETFs, and how can you pick one that works for you?

How is the index weighted?

Most ETF investors start with "traditional" stock indexes, which weigh companies according to their market capitalization. This means that the companies with the highest total stock market value (share price times the number of shares outstanding) get the most weight in the index—hence the name "cap-weighted" indexes.

Other weighting systems exist, including equal weighting, fundamental weighting, and low-volatility weighting, but even focusing on just the traditional cap-weighted indexes leaves you with a lot of choices.

Who are the index providers?

Some of the biggest providers of cap-weighted stock indexes are Standard and Poor's (S&P) Corporation, Russell Investments, MSCI, Inc, Dow Jones (now part of the same company as S&P) and FTSE Group. Smaller players include Morningstar Inc., CRSP (the Center for Research in Security Prices) and providers of alternative weighted indexes such as RAFI (Research Affiliates, LLC) and WisdomTree Investments, Inc.

Barclays Capital is the biggest name in bond indexing, with other bond indexers having very little market share at all. Similar to stock indexes, most bond indexes are weighted by market capitalization. In the case of bonds, though, this means that the most-indebted issuers tend to have the most weight in the index, since they have borrowed the most money and therefore have the most bonds outstanding.

Which securities do they include for tracking?

Each index provider looks at a different universe of stocks and bonds, even within the same asset class. For example, for a US stock index, some providers might exclude companies that do business in the United States but are legally headquartered in the Cayman Islands for tax purposes, while other providers might include them. Some might build a broad market benchmark of 1,500 stocks, while others might include 4,000 or more. The exact threshold for how large or how liquid a company must be before being included in a broad index can also vary across index providers. Some index providers use a rules-based methodology while others use a more subjective methodology.

In practice, these differences don't matter much when it comes to index performance. Even the major index providers agree (based on anecdotal evidence) that their broad-market indexes don't differ significantly.1

Different ways to slice the market

Where providers do vary is in their definition of what type of security belongs in which category. The most salient examples are in their categorizations of market cap, country classification, sector and style. 

Market cap. Investors who look into indexing in detail are often surprised to learn that "large cap," "mid cap" and "small cap" have no formal definitions and vary from firm to firm. The general approach is to rank stocks by market capitalization (the total value of outstanding shares) and then to set cut-off ranks for the different size indexes. Some providers have non-overlapping indexes, while others carve the mid-cap index out of the lower end of the large-cap index and/or the higher end of the small-cap index.

Different approaches to capitalization

Market Capitalization (General Targets)
Index Family Large Cap Mid Cap Small Cap
S&P The largest 500 stocks Stocks ranked 501-900 Stocks ranked 901-1,500
Russell The largest 1,000 stocks Stocks ranked 201-1,000 (part of large cap) Stocks ranked 1,001-3,000
Dow Jones U.S. Total Stock Market The largest 750 stocks Stocks ranked 501-1,000 (part of both large and small cap) Stocks ranked 751-2,500

Sources: S&P U.S. Indices Methdology, March 2012; Russell U.S. Equity Indexes Construction and Methodology, August 2012; Guide to the Dow Jones U.S. Total Stock Market Index Family, undated (retrieved January 2013).

Country classification. Which countries are developed, emerging or frontier markets? Any classification system will involve borderline cases, and a country's level of development can change over time. A prominent example is South Korea. MSCI, a widely-followed provider of international stock indexes, currently classifies South Korea as an emerging market. FTSE, a provider growing in acceptance in recent years, classifies it as a developed market. Thus, when a major fund company recently moved the underlying benchmark index for its international index funds from MSCI indexes to FTSE indexes, South Korea's standing in the emerging market fund morphed from number one to nonexistent. This can create turnover in index funds and cause meaningful differences in performance if South Korea performs much better or much worse than other emerging-market economies.

Sectors and styles. Stock indexes are often broken up into smaller indexes that track styles such as growth, value and blend (core), or economic sectors like technology, consumer staples and health care. To determine style, index providers typically focus on characteristics such as a company's price-to-earnings ratio (P/E) and earnings growth rate. Some classify companies as growth or value only, while others count borderline companies partially in the growth index and partially in value. Some providers have "pure growth" and "pure value" versions of their indexes, which exclude borderline companies entirely.

For sectors, the broad strokes tend to be similar, with stocks classified into one of about ten sectors. Some providers, however, refer to "consumer staples and consumer discretionary" while others have "consumer cyclical and consumer non-cyclical," and the treatment of telecommunications relative to technology also varies. Unless you're investing in specific sector indexes, these differences don't usually matter much since the broader indexes will simply include all of the sectors.

Performance impact

When it comes to US total market indexes, the biggest providers (S&P, Russell and Dow Jones) have all been very similar over the past 17 years, finishing within $950 of one another over that long time frame assuming an initial investment of $10,000.

Growth of $10,000: US Total Stock Market Indexes

Growth of $10000: US Total Stock Market Indexes

Source: Morningstar Direct as of December 31, 2013.

Large-cap stock indexes have seen a little more variation in returns, with the Dow Jones index lagging slightly over the whole period. The Dow Jones index performed a bit better during market downturns, while S&P and Russell gained a bit during extended market rallies.

Growth of $10,000: Large Cap US Stock Indexes

Growth of $10,000: Large Cap US Stock Indexes

Source: Morningstar Direct as of December 31, 2013.

For small-cap stock indexes, the Russell 2000® index has lagged steadily behind the other indexes over this time period. It's worth noting that the Russell index includes more stocks than the other two, including "micro-cap" stocks that the other indexes exclude. Thus, the Russell 2000 can be seen as the most broadly diversified, though this has not translated to stronger performance in recent decades.

Growth of $10,000: Small Cap US Stock Indexes

Growth of $10000: Small Cap US Stock Indexes

Source: Morningstar Direct as of December 31, 2013.

What if your ETF's index composition changes?

It is worth taking the time to compare the new index to the old index. For broad equity indexes, the differences may be negligible but in other cases, your portfolio make-up may change; for example, if an emerging-market index adds or removes a major country. In such cases, you'll want to make sure that the new index still fits with your portfolio and that the costs of changing indexes are acceptable to you (increased turnover could lead to higher transaction costs and potentially capital gains distributions). If the new index still fits your needs, you can stick with it.

Zero in on costs

Because the actual differences in cap-weighted indexes tend to be fairly small, investors should focus on the cost of investment. Generally, investors will be accessing indexes through index mutual funds and ETFs, whose costs can vary. Focus on controlling what you can control: the cost of your investments.

1. Index provider panel at 2013 Inside ETFs conference.

Next Steps

How to Understand Option Greeks
3 Ways to Build an All-Index ETF Portfolio
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