Stepping up to the plate to take your first swing at ETF investing has never been simpler and more cost effective, but as eager investors approach these products, are they really understanding the differences in portfolio composition? Index formulation methodology could likely have a much greater impact on bottom-line performance than fee structure over time. Now that we have a fair amount of price history for comparative analysis, the differences in index construction can amount to a sizeable margin of total return over time.
This is precisely why many exchange-traded product providers are setting their sights on challenging the traditional cap-weighted styles for more exotic, alternative, or smart index strategies. However, these innovative strategies still have a big hill to climb, as cap-weighted indexes still control the largest share of assets under management in the ETF universe.
There is no hard and fast rule to index selection, which is why investors need to be more conscious than ever about the options that are available and how to ultimately select an appropriate fund.
There are three primary index construction techniques that publishers use to construct the allocation size in an equity-oriented ETF: market capitalization weight, equal weight, and fundamental weight.
Let’s begin with the index blueprint that most investors are familiar with: market-cap weighting sizes constituent securities according to the total market value of their outstanding shares. In a real world example, examining the PowerShares NASDAQ 100 ETF (QQQ), Apple AAPL (AAPL) occupies roughly 12.5% of the fund due to its $500 billion market cap. On the flip side, the smallest holding, F5 Networks FFIV (FFIV), only occupies 0.17% due to its much smaller $7 billion market cap.
Quite simply, a cap-weighted index will advance or decline more dramatically in value in response to the changes in market value of larger holdings vs. smaller holdings. One inherent benefit to this style of index composition is that traditionally larger, more established companies will present less volatility than smaller ones.
However, it’s also important to bear in mind that investors who select cap-weighted indexes are essentially disproportionately tilting their equity allocations toward larger companies that can inhibit performance characteristics over the long term. In a recent study by Goldman Sachs Asset Management that examined the stock market over the past 20 years, it was proven that small and mid-cap stocks have outperformed large cap stocks by a fair margin while presenting only slightly higher volatility.1
Using the same scenario, equal weight indexes are often created using the same list of stocks as cap-weighted indexes. However, instead of examining the size of the company, an equal weight index allocates identical proportion amongst all the constituent securities. So, Apple Inc. would carry an identical weight within the index as F5 Networks, which is the goal behind the NASDAQ-100 Equal Weighted Index. At first glance, this type of weighting strategy might seem illogical in relation to the aforementioned cap weighted style, as investors may instinctively want to own a larger share of mature, successful companies. But, it can often be prudent to carry a larger slice of the pie in small and medium capitalization companies in a rising market environment.
Using a relevant 2013 performance comparison, the cap-weighted SPDR S&P 500 ETF (SPY) has gained 28.97%, while the Guggenheim Equal Weight S&P 500 ETF (RSP) is up 31.74%, a divergence of 2.77%. In comparison, RSP carries an expense ratio nearly four times higher than SPY at 0.40%, making for a compelling value proposition even in light of a higher fee structure. Investors should also be mindful that a larger portion of their invested capital is allocated to companies that are smaller in size, which has been known to exhibit higher beta over time.
Relatively new when compared to the other two strategies, the last type of index methodology is a fundamentally weighted group of stocks. These indexes are developed to account for comparable company metrics such as book value, earnings, revenue, or even dividend rates. Companies exhibiting the strongest traits based upon the screening methodology are then assigned the largest weight within the index.
The beauty of fundamentally allocating to companies using performance based metrics is the ability to overweight a company that is currently undervalued by the market, and vice-versa for overvalued examples. It also gives investors the ability to zero in on a specific metric, such as free cash flow, and apply that metric across a single sector. A striking example illustrating the effectiveness of fundamentally weighted strategies could be made using the First Trust Consumer Staples SPLS AlphaDex ETF (FXG) and the SPDR Consumer Staples ETF (XLP). FXG is currently up 39.83% year-to-date, while XLP has risen 25.44% through the same time frame, totaling a staggering divergence of 14.39%.
Selection and Application
Choosing the right index for your personal needs doesn’t come down to typical investment roadblocks such as size or accessibility, but rather your individual goals and tolerance for volatility. In other words, investors have become accustomed to traditional market-cap weighted indexes due to their long running history. This is precisely why you should ask yourself whether you feel comfortable stepping outside the classical approach to index investing. In reality, you could conceivably pay a higher fee in order to gain the potential reward that the index you choose hits the market’s sweet spot.
As demand evolves for more complicated and specific benchmarks, index construction is growing far more complex. Regardless of strategy, it is imperative that investors demand that index providers bring the highest quality, objective, transparent and rules-based indexes to the market. Indexers must ensure that they have the best available data and technology to match the growing complexities, and methodologies must remain open and transparent to allow for optimal tracking by investors, product issuers and traders.
The overarching conclusion that can be drawn from the differences between these three strategies is the universal shift from overweight positions in large well-known names to concentrated positions in smaller, more nimble, or fundamentally sound companies. These traits should immediately appeal to those investors seeking the chance to outperform traditional benchmark indexes, but it will likely come with the cost of increased volatility over time. Conversely, cap weighted indexes might still be the right fit for investors who believe in the strength of large companies to dominate a specific segment of the market, and don’t want to risk the chances of underperforming traditional market barometers. Undoubtedly, the market for alternative index strategies is growing and attracting assets. Educating yourself on the intricacies of these new products and their potential benefits will ultimately strengthen your investment selection process. Performing your own due diligence alongside your individual goals should lead you down the path of picking the appropriate index that meets your unique investment needs.
*Performance data provided by Yahoo! Finance Through November 30th, 2013
1 Goldman Sachs Asset Management White Paper “The Case for Mid-Cap Investing” June 2013, p. 2 [PDF]
The article originally appeared on Forbes.com.