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