3 Types of Indexing for ETF Success

The dominant driver of performance in an exchange-traded fund (ETF) is the index with which it is paired. If you can select the "best-fit" index for your personal needs, you are on the road to ETF success. However, deciphering indexes is one of the more demanding tasks in the investment field, and it is not getting easier. There are three dominant types of indexes to consider: market-cap weighted, equal-weighted, and fundamental.

Indexing has become an innovation-driven science, and investor acceptance of new concepts has fueled a "great debate" about which indexing methods will produce superior performance over time. In this article, we will discuss key points in this debate while comparing three genres of indexing: market cap weight, equal weight, and fundamental indexing.

Defining Investment Performance

Investment indexes are designed to mirror the average performance of financial markets. For example, the most successful index in history is the Standard & Poor's 500 Index (S&P 500).

The S&P 500 index assigns 500 component stocks, a weight that reflects each stock's market capitalization and the total value of all shares of stock outstanding. One advantage of such a market-cap weighted index is simplicity. As stock prices change daily, the weightings of index components automatically adjust.

However, there are also drawbacks to this method, starting with a fairly heavy concentration in the largest stocks. As of Dec. 21, 2020, the top 10 stocks (shown below) accounted for 27.25% of the S&P 500 index weight and performance, based on the SPDR® S&P 500® ETF Trust, which is used as a proxy for the S&P 500 index.

Top 10 S&P 500 holdings and weightings as of Feb. 9, 2021:

1. Apple (6.58%)
2. Microsoft (5.4%)
3. Amazon.com (4.39%)
4. Meta Platforms Inc. (formerly Facebook) Class A (2.11%)
5. Tesla (1.58%)
6. Alphabet Inc. Class A (1.67%)
7. Alphabet Inc. Class C (1.62%)
8. Berkshire Hathaway Inc. Class B (1.40%)
9. Johnson & Johnson (1.29%)
10. JPMorgan Chase & Co. (1.21%)

Many other leading U.S. equity indexes have similar market-cap weighting and top-heavy bias toward large companies. These include the Russell 1000 (RUI), Russell 3000 (RUA), and Wilshire 5000 Total Market Index (TMWX). Each of these indexes includes more components than the S&P 500, which tends to lower the weighting of its top holdings.

Market-cap-weighted indexes are tilted toward large companies, therefore, they generally perform best when large-caps outperform mid- or small-caps. Also, these indexes perform well in momentum-driven markets. During the late 1990s bull market, the S&P 500 became heavily weighted toward tech stocks and, thus, became more vulnerable to the crash in prices that followed in 2000-2002. According to Standard & Poor's, the allocation of the S&P 500 Index increased from 11% in the technology sector at the start of 1995 to a peak of 34.3% in March 2000. As of Nov. 30, 2020, technology accounted for nearly 28% of the index.

The Value of Equal-Weight Indexes

An alternative to a market-cap weighted benchmark is the Standard & Poor's 500 Equal-Weight Index. Instead of tilting toward the largest companies, this index assigns the same weighting to each of its constituents. For example, the S&P 500 gives a 0.2% weight to each of the 500 components and rebalances quarterly to adjust for changes in market values. The Invesco S&P 500® Equal Weight ETF (RSP) is an example of an S&P 500 equal-weight ETF.

An equal-weight index tends to perform better than a market-cap weighted index in environments that favor mid- or small-cap stocks. The equal-weight index also has the advantage of avoiding excessive valuations during momentum-driven markets.

Some investors believe the choice between a market-cap weighted index and an equal-weight index is minor. However, the performance difference can be surprisingly large. The broadest of all U.S. stock market indexes are published by Wilshire Associates and include more than 5,000 component stocks, which account for more than 99% of all U.S. publicly traded equities. The table below compares the performance of the equal-weight version of this index with the market-cap-weighted version. Both versions hold the same components.

Rebalancing Cost Drag

Unlike the Russell, Dow Jones, and Wilshire indexes, in which components are selected mechanically based on "quant" statistics, the S&P 500 is driven by a committee approach to stock inclusion and turnover. Turnover refers to how often the components of a portfolio are bought and sold, which can lead to higher transaction costs if this is done more often. Since indexes are rebalanced from time to time in order to restore the target weights, the frequency of this turnover can be a cost consideration.

Both market-cap weighted and equal-weight indexes of the same sponsors tend to change components at the same time. The difference is that the equal-weight indexes must be rebalanced back to the target weightings periodically, while the market-cap-weighted indexes are not rebalanced to correct for market price changes. Rebalancing generates a few basis points per year of cost drag in ETFs that track equal-weight indexes.

Fundamental Indexing Enters the Debate

Based on research conducted by Rob Arnott, chair of Research Affiliates, a new concept in indexing was introduced in 2005 as a joint venture between the FTSE Group and Research Affiliates. The broad-based U.S. equity index FTSE RAFI 1000 selects 1,000 components based on a rule-based model that includes sales, cash flow, book value, and dividends.

A fundamental index attempts to go beyond the concept of mirroring the experience of an "average investor," by selecting and weighting component stocks based on the current and quantitative ranking of company data.

When the FTSE RAFI 1000 was paired with an Invesco ETF to form the Invesco FTSE RAFI US 1000 (ARCA: PRF), it proved so popular with investors that Invesco has since rolled out a large menu of fundamental ETFs. WisdomTree Investments and Claymore Securities also promoted the concept by launching ETFs tied to fundamental indexes. Over the last year as of Dec. 22, 2020, the FTSE RAFI US 1000 has returned 6.71%, underperforming both S&P 500 indexes, the equal-weight and the market-weighted ones.

Research Affiliates contends that the benefit of fundamental indexing is in tempering portfolio risk, especially during momentum-driven markets. By selecting and weighing components based on company data, and periodically rebalancing the index to reflect new data, the fundamental index will tend to have a lower price/earnings ratio (P/E ratio) and less volatility than market-cap-weighted indexes.

Performance data also suggests that fundamental indexes may tend to overweight value stocks and underweight growth stocks relative to comparable market-cap-weighted indexes. Over long periods of time, Research Affiliates claims that fundamental indexing should produce a small, but meaningful, performance edge over market-cap-weighted indexes.

The Bottom Line

For investors, perhaps the best way to learn more about any type of index is to allocate a portion of a portfolio to it via ETFs or index mutual funds and then track it against alternatives, over time.