The vast majority of exchange traded funds (ETFs) track indexes, but not all indexes are weighted equally. In fact, how an index does its weighting can have a noticeable impact on your returns in different environments.

By far, the most common weighting method is that of market-cap weight.

What It Is

Market-cap weighting refers to a stock market index that weights each stock by the market capitalization of each stock in its index. The advantage of this methodology is its simplicity: weightings of index components can be easily adjusted to reflect the ever-changing stock prices for each trading day.

However, a market-capitalization weighted index construction is heavily swayed by its top stocks, which may make up a hefty percentage of the overall index. For instance, the S&P 500 index holds a large percentage of its overall weightings in the top 10 stocks of the index and any major shifts in those companies would have a greater impact on the overall index.

This puts market-cap weighted indexes in favor when the environment for large-caps is favorable. In periods of weakness for big corporations, though, market-cap weighting can become less appealing.

Other U.S. equity indexes that also have market-cap weightings with a top-heavy bias toward large and established companies include the Russell 1000, Russell 3000 and Wilshire 5000 Total Market Index. These indexes do have more components than the S&P, which would reduce the heavier tilt toward the top companies.

Pros and Cons

Subscribe to our free daily newsletters!
Please enter your email address to subscribe to ETF Trends' newsletters featuring latest news and educational events.