Comparing YTD Returns for Different ETF Indexing Methodologies

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Michael Johnston submits:

By Cathy Carlson

The first generation of equity ETFs was dominated by market capitalization-weighted strategies, a methodology that involves assigning a weight to each component based on the total value of its equity. Most of the assets in equity ETFs can still be found in cap-weighted funds, but that strategy is no longer the only game in town. In recent years, a number of alternative weighting strategies have become popular with investors, including:

  • Equal Weighting: An equal-weighted index holds an equal dollar amount of each of the component companies. This technique requires regular rebalancing because the value of stocks shift, causing a change in the security's individual weighting.
  • Earnings Weighting: This methodology determines the appropriate asset allocation based off of a company's reported earnings. Companies with higher earnings will have higher weightings in the index. The technique may have a tendency to be heavy in value stocks, avoiding companies with negative earnings (many growth companies have negative earnings).
  • Dividend Weighting: Like the earnings-weighted index, this strategy gives its highest allocation to the security that has paid out the highest cash dividends. There are a number of potential advantages to this strategy, including an avoidance of firms that engage in "cooking the books."
  • Revenue Weighting: This strategy involves weighting each component by top-line revenue, a technique that overweights low price-to-revenue companies and underweights companies with a high price-to-revenue ratio.

With the first half of 2010 in the books, we take a look back to see which of these strategies have performed the best through the first two quarters of the year. Two words of caution; first, while the components of the ETFs profiled are generally very similar, they won't always be identical. As such, the weighting methodology isn't the only variable (although it is definitely the primary difference within each group below). Second, the tables show results over a six-month period, a time frame that isn't long enough to draw any definitive results. Still, the results are very interesting, and demonstrate that a tweak to weighting methodologies can have a material impact on bottom line returns.

Large Cap Equities

Considering that SPY is the largest ETF by total assets, it isn't surprising that there have been a number of "spin off" funds that hold similar components but utilize different weighting strategies. But it has lagged behind other large cap funds with similar holdings but different weighting methodologies through the first half of the year:

Ticker ETF Methodology 1H '10 Return
[[RSP]] Rydex S&P Equal Weight ETF Equal -4.4%
[[RWL]] RevenueShares Large Cap Fund Revenue -5.8%
[[DLN]] WisdomTree LargeCap Dividend Fund Dividends -6.0%
[[EPS]] WisdomTree Earnings 500 Fund Earnings -6.7%
[[SPY]] State Street SPDR S&P 500 Fund Market Cap -6.9%
All returns as of 6/30/2010

The winner: None of these ETFs has delivered particularly impressive returns, but the equal-weighted index has not experienced as rough of a beating year-to-date.

Mid Cap Equities

An equal-weighted ETF is not offered in the mid cap equities though there are a number of ETFs offering mid cap exposure. Each of these ETFs offers exposure to mid cap equities, with the primary difference being the methodology utilized to determine individual weightings.

Ticker ETF Methodology 1H '10 Return
[[DON]] WisdomTree MidCap Dividend Fund Dividends -0.6%
[[EZM]] WisdomTree MidCap Earnings Fund Earnings -0.9%
[[IJH]] iShares S&P MidCap 400 Index Fund Market Cap -1.5%
[[RWK]] RevenueShares Mid Cap Fund Revenue -4.4%
All returns as of 6/30/2010

The winner: Again, the market cap-weighted ETF lagged behind other strategies, as dividend weighting and earnings weighting were the most effective strategies among mid cap ETFs.

Small Cap Equities

Small cap equities have been among the best performers of the year, but not all funds have turned in equivalent performances:

Ticker ETF Methodology YTD Return
[[DES]] WisdomTree SmallCap Dividend Fund Dividends 2.8%
[[IJR]] iShares S&P SmallCap 600 Index Fund Market Cap -0.9%
[[EES]] WisdomTree SmallCap Earnings Fund Earnings -1.0%
[[RWJ]] RevenueShares SmallCap Fund Revenue -1.8%
All returns as of 6/30/2010

The winner: The dividend-weighted ETF blew the other methodologies out of the water, claiming bragging rights as the only small cap fund to finish the second quarter in positive territory for the year.

Results

Market cap weighting is the most widely known and used technique in constructing equity indexes. But many investors have embraced alternatives to cap-weighting, adopting strategies that use other fundamental factors to determine the allocation given to individual holdings. As demonstrated above, the choice of weighting methodology can have a pretty big impact on bottom line returns, and can sometimes be the difference between positive and negative territory.

Disclosure: No positions at time of writing.

Disclaimer: ETF Database is not an investment advisor, and any content published by ETF Database does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. From time to time, issuers of exchange-traded products mentioned herein may place paid advertisements with ETF Database. All content on ETF Database is produced independently of any advertising relationships. Read the full disclaimer here .

Original post

See also Closed End Fund Discounts on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs


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