“Equal-weighted and fundamental indexes are two such approaches: they use a straightforward construction methodology in order to address potential concentration or valuation concerns inherent in capitalization-weighted indexes,” FTSE Russell said.
Equal weight index constituents, like the name suggests, receive an equal weight, and they are rebalanced regularly to keep components in line. The equal weight methodology helps address concerns about potential concentration risks in traditional capitalization-weighted indices where the largest and most popularly traded companies account for outsized exposures within the index.
Fundamental indices incorporate specific screens when selecting stocks or measures companies based on fundamental measures, such as sales, operating cash flow, dividends and book value – factors that have traditionally been associated with value. The approach favors securities whose prices have diminished while underweighting those whose prices have increased.
“When choosing between standard, capitalization-weighted indexes and smart beta indexes, market participants often bear in mind questions of simplicity and transparency, cost, liquidity, capacity and governance. Index users should also evaluate smart beta in the context of the original objectives, such as the generation of excess index returns, the mitigation of volatility, or diversification. This information is as readily available as it is for capitalization-weighted indexes and should not be an obstacle to considering smart beta alongside more traditional index options,” according to FTSE Russell.
For more information on alternative index-based strategies, visit our smart beta category.