Weighted Indexes: How Are You Choosing Your ETFs?

With the number of exchange-traded funds (ETF’s) growing each year, it is important for you as an investor to understand exactly what you are purchasing if you plan on investing in an ETF.

When you are deciding which ETF to buy, typically you would first decide what general area of the investment universe you want exposure to. One of the factors you may consider is company size, or market capitalization – typically micro-cap, small-cap, mid-cap and large-cap. You may then choose between domestic or foreign equities and the level of economic development – developed, emerging or frontier markets. You could then narrow the field even further by looking at specific sectors, countries or regions.

Once you have evaluated all of these options, one factor that investors often overlook is an equally important characteristic: the way the equities within the ETF are weighted. By far the most common method used to weight an index today is by using the companies’ market cap. In other words, the largest companies are more heavily weighted in the index when compared to the smaller companies.

A recent study done by the Cass Business School at City University London analyzed several alternate weighting methods using the largest 1,000 equities in the U.S. stock market from 1969-2011. The Cass study compared several different weighting methodologies, as shown below:

As you can see from the table above, a surprising finding from the study is that the market cap-weighted strategy, which is by far the most common, was the worst performer. The problem with the market cap-weighted indexes seems to be that you are investing more in overvalued companies and less in undervalued companies.

As indicated above, a weighting based on fundamental factors such as sales or cashflow could potentially provide greater returns over time. Even the equal-weighted indexes tend to outperform the much more popular cap-weighted indexes.

If you are interested in learning more about how we select the most suitable ETF’s for our clients’ portfolios, please call or email me. And if you would like to read the full two-part study by the Cass Business School referenced in this blog, you can download it here:

An Evaluation of Alternative Equity Indices
Part 1: Heuristic and optimized weighting schemes

Part 2: Fundamental weighting schemes

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