Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF?–Part 1: The Basics] [What is an ETF?–Part 3: Enhanced Indexing]
Passive stock exchange traded funds generally follow a simple formula to reflect the performance of an underlying benchmark Index, but not all Indices are created alike. The varying indexing methodologies can generate different returns.
Most ETFs use a type of indexing or passive investment methodology that adjusts the weightings on component holdings within its investment portfolio to reflect that of an underlying index. Additionally, fund providers may use a sampling technique to select a few securities from an overall Index.
The majority of stock-related ETFs employ a market-cap weighted methodology where each stock component is weighted by their market capitalization in the original index.
However, this methodology is heavily influenced by its top 10 holdings, which may make it more vulnerable to a market crash. Still, this is may be a boon when larger companies are outperforming the markets or during momentum driven market conditions.