ETFs and Indexing: What’s Your Style?

April 23rd at 8:00am by Tom Lydon

Many of the simplest index funds exchange traded funds attempt to capture the broad market’s performance. One of the main points of indexing is that beating the market most of the time is difficult, and that stock picking to outperform is even harder.

“Gone are the days when there were only a handful of benchmarks. Indexes that employ unique weighting methodologies as alternatives to market cap weighting have garnered significant attention in recent years, emerging as new tools for tapping into traditional asset classes. Meanwhile, index providers have also been busy fine tuning the rules behind indexes in an attempt to enhance the experience of investors with positions in products linked to these benchmarks,” wrote ETF Database on Business Insider. [ETFs That Carve Out Sectors]

Over the past few years, indexing strategies with ETFs has made it possible to invest in indices that slice and segment various sectors and corners of the markets. Furthermore, strategies can become fine-tuned depending upon market conditions.

Here are a few of the most primary methods of index construction and their structures, reported by Adam Zoll for Morningstar in a recent article:

  • Cap-Weighted Indexing: This is the most common method of indexing; it is through market-cap weighting, in which the amount of each stock held is proportionate to its market value, or capitalization. The index gives a real look into what the market looks like, with a tilt toward large and mega cap companies. In a rising market, the index could include a large weighting to over-priced stocks. [Money Managers Want More Niche ETF Products]
  • Equal-Weight Indexing: All stocks are heldĀ  in equal proportion regardless of market cap. So, for example, an equal-weighted S&P 500 fund would still include the same 500 stocks as the cap-weighted version, but in equal amounts. Mid-sized companies are emphasized, and smaller companies get more exposure than they would in a cap-weighted index. There is not a fair representation of the market through this type of index, and the funds that track these are more expensive. [Why an Equal-Weight ETF is Outperforming in 2012]
  • Fundamental Indexing: Stocks are weighted based on a fundamental metric or metrics, such as dividend yield, earnings, book value, or a combination of factors. The index can be made with a tilt, avoiding areas of the market or sector. Re-balancing is necessary, lots of times, with this type of index, creating more expenses for the investor.
  • Price-Weighted Index: Stocks are weighted by the share price for each company in the index, with the Dow Jones Industrial Average the most famous example. Less trading is necessary with this type of index fund. A slant to overpriced stocks or a breakaway from market values is common.

Tisha Guerrero contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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