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ETFs 101: A Look at Indexing Methodologies

Passive stock exchange traded funds generally follow a simple formula to reflect the performance of an underlying benchmark Index, but not all Indices are created alike. The varying indexing methodologies can generate different returns.

Most ETFs use a type of indexing or passive investment methodology that adjusts the weightings on component holdings within its investment portfolio to reflect that of an underlying index. Additionally, fund providers may use a sampling technique to select a few securities from an overall Index.

The majority of stock-related ETFs employ a market-cap weighted methodology where each stock component is weighted by their market capitalization in the original index.

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However, this methodology is heavily influenced by its top 10 holdings, which may make it more vulnerable to a market crash. Still, this is may be a boon when larger companies are outperforming the markets or during momentum driven market conditions.

The equal weighting methodology tries to balance out the top heavy nature of market-cap weighted indices, equalizing the weightings on all component holdings.

Consequently, mid- and small-cap stocks have a greater say in the fund, which help drive equal-weighted ETF performances during the initial stages of a market recovery. Additionally, historical evidence has shown that over the long run, mid- and small-cap companies tend to perform better over extended periods.

However, equal-weight ETFs will have to rebalance more frequently to achieve its target objective, which may increase the costs of holding the funds.

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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

This article was provided by our partner Tom Lydon of etftrends.com.


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

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