3 types of indexes for ETF success

The main driver of the performance of an exchange-traded fund (ETF) is the index that is paired with it. If you can choose the “most suitable” index based on your personal needs, then you are on the road to ETF success. However, deciphering the index is one of the more demanding tasks in the investment field, and it has not become easier. There are three main types of indexes that need to be considered: market capitalization weighted indexes, equal weighted indexes, and basic indexes.

Indexing has become an innovation-driven science, and investor acceptance of new concepts has triggered a “big debate” about which indexing method will produce superior performance over time. In this article, we will discuss the key points of this debate while comparing three index types: market capitalization weight, equal weight, and fundamental index.

Define investment performance

The investment index aims to reflect the average performance of the financial market. For example, the most successful index in history is the Standard & Poor’s 500 Index (S&P 500).

The Standard & Poor’s 500 Index assigns 500 constituent stocks, and the weight reflects the market value of each stock and the total value of all outstanding shares. One advantage of this market capitalization weighted index is simplicity. As the stock price changes every day, the weights of the index components are automatically adjusted.

However, this method also has disadvantages. The first is the high concentration of the largest stocks. As of December 21, 2020, based on the SPDR® S&P 500® ETF Trust (used as a proxy for the S&P 500 Index), the top 10 stocks (shown below) accounted for 27.25% of the S&P 500 index weight and performance.

As of February 9, 2021, the top 10 S&P 500 index holdings and weights:

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  1. Apple (6.58%)
  2. Microsoft (5.4%)
  3. Amazon (4.39%)
  4. Meta Platforms Inc. (formerly Facebook) Class A (2.11%)
  5. Tesla (1.58%)
  6. Alphabet Inc. Class A (1.67%)
  7. Alphabet Inc. Class C (1.62%)
  8. Berkshire Hathaway Class B (1.40%)
  9. Johnson & Johnson (1.29%)
  10. JPMorgan Chase (1.21%)

Many other leading US stock indexes have similar market capitalization weights and top-heavy biases against large companies. These include Russell 1000 (RUI), Russell 3000 (RUA) and Wilshire 5000 Total Market Index (TMWX). Each of these indexes contains more components than the S&P 500 index, which tends to reduce the weight of its highest holdings.

Market capitalization-weighted indexes tend to favor large companies, so when large-cap stocks outperform mid-cap or small-cap stocks, they usually perform best. In addition, these indexes perform well in momentum-driven markets. During the bull market in the late 1990s, the S&P 500 index became heavily biased towards technology stocks, making it more susceptible to the subsequent price collapse of 2000-2002. According to data from Standard & Poor’s, the allocation of the S&P 500 in the technology sector rose from 11% in early 1995 to a peak of 34.3% in March 2000. As of November 30, 2020, the technology sector accounted for nearly 28% of the index.

Equal weight index value

An alternative to the market value weighted benchmark is the S&P 500 equal weight index. The index does not lean toward the largest companies, but assigns equal weights to each component. For example, the Standard & Poor’s 500 Index assigns a weight of 0.2% to each of the 500 components and rebalances each quarter to adapt to changes in market value. The Invesco S&P 500® Equal Weight ETF (RSP) is an example of the S&P 500 ETF.of

In an environment conducive to small and medium-cap stocks, equal-weighted indexes often outperform market capitalization-weighted indexes. Equal-weight indexes also have the advantage of avoiding excessive valuations in momentum-driven markets.

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Some investors believe that the choice between a market capitalization weighted index and an equal weighted index is secondary. However, the performance difference can be surprisingly large. The most extensive of all stock market indexes in the United States is published by Wilshire Associates and includes more than 5,000 constituent stocks, accounting for more than 99% of all publicly traded stocks in the United States. The following table compares the performance of the equal-weighted version of the index with the market capitalization-weighted version. Both versions have the same components.of

S&P 500 Index performance (as of November 30, 2020)
index 1 year 3 years annualized 5 years annualized 10 years annualized
Standard & Poor’s 500 Index (market capitalization weighted) 14.71% 11.24% 12.82% 11.41%
Standard & Poor’s 500 Index (Equal Weight) 8.93% 7.61% 10.72% 10.30%

Rebalancing cost drag

Unlike the Russell, Dow Jones, and Wilshere indexes, the components of these indexes are mechanically selected based on “quantified” statistics. The S&P 500 index is driven by the committee’s approach to stock inclusion and turnover.

The market value-weighted index and equal-weighted index of the same sponsor often change components at the same time. The difference is that the equal-weighted index must be rebalanced back to the target weight on a regular basis, while the market value-weighted index will not be rebalanced to correct for market price changes. In an ETF that tracks an equal weight index, rebalancing will produce a cost drag of several basis points per year.

Fundamental Index Enters the Debate

According to research by Rob Arnott, Chairman of Research Affiliates, a new concept of index was introduced in 2005 as a joint venture between FTSE Group and Research Affiliates. The broad US stock index FTSE RAFI 1000 selects 1,000 components based on a rule-based model, including sales, cash flow, book value, and dividends.

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Fundamental indexes try to go beyond the concept of reflecting the experience of “ordinary investors”, selecting and weighting constituent stocks based on the current and quantitative ranking of company data.

When FTSE RAFI 1000 was paired with Invesco ETF to form Invesco FTSE RAFI America 1000 (ARCA: PRF), it proved so popular with investors that Invesco launched a large number of fundamental ETFs. WisdomTree Investments and Claymore Securities also promoted this concept by launching ETFs related to fundamental indices. As of December 22, 2020, the return rate of the FTSE RAFI US 1000 Index was 6.71% in the past year as of December 22, 2020, underperforming the Standard & Poor’s 500 Index, Equal Weight Index, and Market Weighted Index.

Research Affiliates believes that the benefit of fundamental indexation is to ease portfolio risk, especially in a momentum-driven market. By selecting and weighting components based on company data, and periodically rebalancing the index to reflect new data, the base index will tend to have a lower price-to-earnings ratio (price-to-earnings ratio) and less volatility than the market capitalization-weighted index.

Performance data also shows that, relative to comparable market value-weighted indexes, fundamental indexes may tend to increase holdings of value stocks and decrease holdings of growth stocks. For a long time, Research Affiliates claimed that the fundamental index should produce a small but meaningful performance advantage over the market capitalization weighted index.

Bottom line

For investors, the best way to understand any type of index may be to allocate a portion of the portfolio to it through an ETF or index mutual fund, and then track it with alternatives over time.

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