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
There are pros and cons to any method of indexing, and market-cap is no exception.
Indexes with a weighted average market capitalization usually perform well when large-cap companies are performing better than mid- or small-caps as a result of the heavier weighting in larger companies. Additionally, this type of index also does well in a momentum-driven environment. But the downside to this scenario is that indexes that are heavily weighted in companies driving the markets may become vulnerable to a crashes or collapsing bubbles.
Market-cap weighting also generates lower portfolio turnover, because as stocks in the index rise in value, so does their weighting in the index. Such lower turnover reduces trading costs.
On the downside, Rob Arnott, an advocate for fundamentally weighted indexes (which we’ll discuss later in this series), has argued that market-cap weighted indexes are inefficient and could lead to underperformance. Arnott points out that capitalization-weighted indexes overweights stocks that are trading above their fair value and underweights stocks that are trading below their true fair value, which would result in diminished returns on market-cap indexes.
Adding Market-Cap to the Mix
Before adding an allocation to market-cap weighted ETFs into your clients’ portfolios, be sure to consider the current economic environment and how favorable it may be to large-caps at the time you’re making the allocation.
It’s also important to bear in mind the issue of index overlap. Because many of the same companies may make an appearance in multiple indexes, be sure that you’re not inadvertently becoming overweight.
If you’re researching ETFs and aren’t sure of the indexing methodology, you can find this information on the fact sheet for any ETF in our ETF Resume tool.