How an exchange traded fund’s (ETF’s) underlying index is constructed is not an insignificant piece of information. An index’s methodology determines how the fund moves, the companies it tracks, how heavily they’re weighted and, overall, the performance of the fund.
There are two main weighting methods: market-capitalization and equal-weighting. There are two funds that track the S&P 500 that employ the two different methods: Rydex S&P 500 Equal Weight (NYSEArca:RSP) and the SPDR S&P 500 (NYSEArca: SPY). [A few ETFs that track the major indexes.]
Although both indexes are comprised of the same stocks, the different weighting schemes result in two indexes with different properties and different benefits for investors, says Ken Hawkins for Investopedia. [Does it matter how your ETF is weighted?]
This is how the indexes work:
- Market-Cap Weighted. The market cap of each stock is determined by taking the share price and multiplying it the number of shares outstanding. The companies with the largest market capitalizations, or the greatest values, will have the biggest weights in the index. The weight of a company in the index is equal to the market cap of that company divided by the total market cap of all the companies in the index. SPY uses this weighting method.
- Equal Weight. Every stock in the index has the same weight, regardless how large or small the company is. Therefore, even Exxon Mobil (NYSE: XOM) will have the same weight (0.2%) as the smallest company that is a constituent in the S&P 500.
The different weighting schemes will result in a variety of sector exposures, as well as the exposure to small- and large-cap companies. The market-weighted indexes are also adjusted, so it is necessary to check the weightings accordingly. There will be adjustments to reflect companies that have been removed and new companies that have been added to the index.