How are securities weighted in traditional ETFs versus alternative ETFs?

 

An index is a group of securities chosen to represent an unbiased view of the risk-reward attributes of a market or a portion of a market. Vanguard believes that because of this, indexes should be constructed according to the market capitalization of the underlying constituents.

In other words, Vanguard believes a true market index should reflect what the market actually is—investors' aggregate holdings of all individual securities in the market. An index that represents the entire market would comprise all publicly traded shares of each company, and by doing so it would naturally be market-cap-weighted. Companies whose shares accounted for the largest market value would have a larger weighting in the index.

 

Market-capitalization methodology

For equity markets indexes, weighting securities according to their market capitalization is the most commonly used method. Market-cap-weighted indexes reflect the consensus estimate of each company's value at any given moment. In any open market, new information—economic, financial, or company-specific—affects the price of one or more securities and is reflected instantaneously in the index via the change in its market capitalization.

Because the current price reflects every possible factor that an investor can use to estimate a company's value, a market-cap-weighted index represents a true multifactor approach to investing.

A market-cap-weighted index is an "all factor" index

 

Alternative weighting methodologies

During the first decade of ETFs' existence, most were based on traditional market-cap-weighted indexes. Over time, a small minority of the investment community criticized the use of market-cap-weighted indexes based on their perceived inefficiencies. This led to a proliferation of ETFs based on alternative strategies such as equal weighting and fundamental weighting. Many ETF issuers realized that any new products they might offer would replicate what already existed, so they looked for alternative strategies to build their ETFs.

Our analysis has shown that these alternative strategies:

  • Are best described as passive, rules-based investment strategies focusing on a small number of factors.
  • Have not successfully captured market inefficiencies consistently across time.
  • Have weighting differences versus market-cap-weighted indexes, demonstrating systematic tilts over time toward smaller-cap stocks or value stocks, or both.
Fundamental-weighted strategy | more

In a fundamental-weighted approach to indexing, companies are weighted based on financial-valuation metrics, such as earnings, revenue, assets, and book value. Proponents of this indexing strategy claim that using these financial-valuation metrics is a better measure of the market because a market-cap-weighted approach tends to overweight companies that are more richly valued while underweighting companies that have lower valuations.

This approach tends to tilt toward a value bias. For example, if an index is weighted by earnings, stocks with higher earnings yields will be overweighted relative to stocks with lower earnings yields. In this case, there would clearly be a bias toward value companies compared with a market-cap-weighted index.

Dividend-weighted strategy | more

A type of fundamental-weighted strategy, this approach weights stocks based on current and/or expected dividend payments. For example, the Dow Jones U.S. Select Dividend Index comprises a group of stocks from the Dow Jones U.S. Total Stock Market Index that have valuation metrics and weightings based on the amount of dividends they pay annually.

This strategy differs significantly from a market-cap-weighted index approach. Dividends may not be the best measure of a stock's potential for total return. Because of the way dividends are paid, it is important to understand that a company's prospects are not rosier because of the distribution of earnings. In addition, companies that pay dividends tend to be larger and tend to exhibit more value like traits.

Equal-weighted strategy | more

An equal-weighted strategy gives an identical static weighting to each security, so the performance of every stock in the target index has the same impact on the index's returns. For example, in an equal-weighted strategy, small and large companies have the same weighting in an ETF. This limits the exposure of a larger, more popular stock in the portfolio in an effort to avoid overweighting it.

At first glance, an equal-weighted approach may appear to enhance diversification, since no single stock contributes more to performance than another. Compared with a market-cap-weighted portfolio, an equal-weighted portfolio is more heavily concentrated in smaller companies and in companies trading at low prices relative to their book value.

For example, by equal weighting the S&P 500 Index, the risk and return characteristics of this index change to those of a mid-cap market-weighted index. Also, since equal weighting in an index tends to favor small- and mid-cap stocks—which have the potential to be more volatile than large-cap stocks—a sudden market downturn can result in increased uncertainty.

Price-weighted strategy | more

In a price-weighted approach to indexing, the weighting of each stock is in proportion to its price per share. The value of the index is calculated by simply adding the price of each stock and dividing the total by the number of stocks. As a result, stocks with higher prices will have more weight in the index and thus have a greater influence on the index's performance.

The Dow Jones Industrial Average is a very well-known stock market index that is price-weighted. It includes the price-weighted average of 30 actively traded blue-chip stocks.

All investing is subject to risk, including possible loss of principal.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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