While much of the financial world is in a state of uncertainty
that has left investors apprehensive, market darlings such as Apple
have headed for the stratosphere.
In the world of indexing, the meteoric rise of Apple, Google and
other technology companies has created a divergence between
market-cap-weighted ETFs and their fundamentally weighted
The divergence is growing too:Valuation multiples for select
tech companies have expanded skyward and continue to comprise an
ever-greater portion of market-capitalization-weighted ETFs and
Market-cap-weighted indexes, such as the S&P 500, and the
ETFs that track them, increase the size of their holdings as the
security itself becomes more expensive. So, as the share price of
Apple Inc. (Nasdaq:AAPL) increases, ETFs that track
market-cap-weighted indexes buy more of it.
To some, this implies that the ETF is definitively 'behind the
curve,' and begs the question, Is paying for popularity a sound
In contrast, fundamentally weighted funds use factors such as
sales, cash flow, dividends and book value to determine relative
To drive home the point, fundamentally weighted ETFs have
actually reduced exposure to many of this year's hottest tech
companies at the same time as market-cap-weighted funds are
boosting exposure and droves of investors are busy talking
themselves into jumping into Apple before it's too late.
Two popular funds that offer exposure to the same space make the
point perfectly. They are:
- PowerShares' FTSE RAFI US 1000 Portfolio (NYSEArca:PRF), a
fundamentally weighted fund with an index designed by Rob
Arnott's Research Affiliates that has assets of $1.45
- State Street's SPDR S&P 500 ETF (NYSEArca:SPY), the first
U.S.-listed exchange-traded fund and the biggest in the world,
with assets of more than $118 billion
The first chart compares the two funds' holdings at the start of
this year and the latter chart compares them at the end of the
third quarter of 2012.
The difference between the two underscores the distinction
between fundamental and market-cap-weighted funds:While PRF has
maintained weighting allocations in line with fundamentals, SPY has
captured market optimism in its market-cap-weighted index.
A grounded comparison between the two is that fundamentally
weighted ETFs pay for realized performance, whereas
market-cap-weighted funds-because they are affected by price-tend
to factor in optimism, or pessimism, about future performance.
To me, a comparison between the two weighting methods
illustrates a deeper, more theoretical difference.
The efficient-market view is a popular one, and fans may
appreciate market-cap weighting, as the theory goes, for inherently
including 'all known information' in a security's price.
Investors who believe that markets are less than perfectly
efficient may appreciate that fundamentally weighted funds are less
subject to fluctuations in sentiment regarding a particular
security and instead base their weightings on realized
If you believe that the hype surrounding many of this year's
hottest tech companies will come to fruition, you may be partial to
market-cap-weighted portfolios such as SPY's, where top tech
companies easily have the largest allocations.
If, however, you're skeptical of the hype and prefer to
maintain allocations in line with realized fundamentals, or simply
prefer the smaller allocations to many of today's 'hottest' tech
companies, then you may prefer fundamentally weighted funds such as
Ultimately, one weighting method is not necessarily better than
the other, but if you believe that what goes up must come down, or
that the mighty will fall, sticking to fundamentally weighted
portfolios may better serve your interests.
At the time the article was written, the author had no positions
in the securities mentioned. Contact Spencer Bogart
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