Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF?–Part 1: The Basics] [What is an ETF?–Part 3: Enhanced Indexing]

Passive stock exchange traded funds generally follow a simple formula to reflect the performance of an underlying benchmark Index, but not all Indices are created alike. The varying indexing methodologies can generate different returns.

Most ETFs use a type of indexing or passive investment methodology that adjusts the weightings on component holdings within its investment portfolio to reflect that of an underlying index. Additionally, fund providers may use a sampling technique to select a few securities from an overall Index.

The majority of stock-related ETFs employ a market-cap weighted methodology where each stock component is weighted by their market capitalization in the original index.

However, this methodology is heavily influenced by its top 10 holdings, which may make it more vulnerable to a market crash. Still, this is may be a boon when larger companies are outperforming the markets or during momentum driven market conditions.

The equal weighting methodology tries to balance out the top heavy nature of market-cap weighted indices, equalizing the weightings on all component holdings. Consequently, mid- and small-cap stocks have a greater say in the fund, which help drive equal-weighted ETF performances during the initial stages of a market recovery. Additionally, historical evidence has shown that over the long run, mid- and small-cap companies tend to perform better over extended periods.

However, equal-weight ETFs will have to rebalance more frequently to achieve its target objective, which may increase the costs of holding the funds.

[What is an ETF?–Part 1: The Basics]

[What is an ETF?–Part 3: Enhanced Indexing]

Max Chen contributed to this article.

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