Weighted Indexes and Selecting Exchange-Traded Funds (“ETFs”)

The market for exchange-traded funds is rapidly expanding, which is why advisors need to perform proper due diligence before investing.

The First Step

We can start by selecting an ETF by size and/or market capitalization (anything from micro to large-cap), then choose from domestic or foreign equities at various levels of economic development. In fact, advisors and their clients can get as granular as choosing individual countries, regions, or sectors. Delineating the asset class by style, including value stocks, growth stocks, or a combination of the two is an option as well.

Assuming all the above, an often-overlooked aspect when researching exchange-traded products is the distribution of weights within the fund.

The Weight

A Cass Consulting study, published in March 2013, inspected a number of alternative weighting schemes formed using the largest 1,000 equities in the U.S. stock market from 1969-2011. This study was meant to show the effects that weighting methods potentially have on volatility and performance.

In today’s investing world, weighting by market cap is one of the most common methods. This means that the weight of each stock is equal to its market capitalization divided by the sum of the market capitalization of all stocks in the index.

Cass went even further. They formulated the dividend-weighted index by dividing the five-year average total dividend payout for each stock by the five-year average total dividend payout of all stocks to obtain the weight for each company. For reasons of consistency, their research used the same process for total annual cash flow, total annual sales, and book value to calculate those indices.

Lastly, they drafted a “fundamentals” composite-weighted index, which factors the dividend weight, average cash flow weight, sales weight, and book value weight of all companies in the index. These four metrics are an average of the composite index weight.

Alternative Equity Indices

Weighting MethodologyReturnStandard Deviation
Based upon a data set (utilized in Cass study, linked above) that comprises the largest 1,000 U.S. stocks for each year from 1969-2011
Book Value-weighted10.70%15.70%
Fundamentals composite-weighted11.00%15.30%
Inverse Volatility-weighted11.40%14.60%
Market cap-weighted9.40%15.30%

Based upon a data set (utilized in Cass study, linked above) that comprises the largest 1,000 U.S. stocks for each year from 1969-2011

The ever-popular market cap-weighted strategy deployed by one of the largest ETFs in the industry, SPDR S&P 500 ETF (SPY), was rated as the absolute worst performer, as noted above. Market cap-weighted indices focus more on investing in overvalued companies than the underdogs, leaving less room for large extensions of growth.

As indicated by the Cass study, a weighting system based on fundamental factors tied to accounting measures, such as sales or earnings, could potentially provide above average returns.

Available Options

For your convenience, here’s a list of alternative-weighted ETFs below:

  • Beta-weighted: PowerShares S&P 500 High Beta (SPHB)
  • Beta-weighted: Russell 2000 Low Beta ETF (SLBT)
  • Dividend-weighted: WisdomTree Total Dividend Fund (DTD)
  • Dividend-weighted: WisdomTree U.S. Dividend Growth Fund (DGRW)
  • Equal-weighted: Guggenheim S&P 500 Equal Weight ETF (RSP)
  • Earnings-weighted: WisdomTree Earnings 500 Fund (EPS)
  • Fundamentals composite-weighted: First Trust Large Cap Core AlphaDEX Fund (FEX)
  • Fundamentals composite-weighted: PowerShares FTSE RAFI US 1000 (PRF)
  • Momentum and Trend-weighted: PowerShares DWA Technical Leaders (PDP)
  • Revenue-weighted: RevenueShares Navellier Overall A-100 Fund ETF (RWV)
  • Volatility-weighted: PowerShares Low Volatility (SPLV)
  • Volatility-weighted: iShares All Country Minimum Volatility (ACWV)

Final Thoughts

Taking the time to understand all the nuances of the ETF you are about to invest in is of vital importance. Understanding the intricacies of your investment option will better equip you to adapt to various market conditions and adjust the portfolio as necessary. While using a weighting system based on fundamental factors has shown the potential for above-average returns over time, past performance is no guarantee of future success.

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