These days it seems that nearly every new ETF brought to market is somehow marketed as a miracle cure for your ailing investment portfolio. Without exception, each new product launch is based on a more specific or exotic security selection methodology, resulting in an unending barrage of innovative resources at your disposal. However, the key to understanding these strategies is narrowing the field to a handful of ETFs that will ultimately help you achieve your goals.
Selecting an ETF by Weighting Methodology
Selecting the appropriate ETF for your individual investment goals begins with a basic understanding the categories funds use to index, or weight, their assets. These methodologies can be sorted into four primary groups: equal weight, capitalization weight, smart beta, and fundamental weight.
While each one has its own unique intricacies, capitalization weight is by far the most common and should be considered the benchmark for broad-based market exposure. These indexes are inherently designed to allocate their constituent holdings based upon the total value of their outstanding shares, or enterprise value.
Hypothetically, Apple Inc. (AAPL) would carry a much larger weighting than Facebook (FB) in a technology index due to its roughly $600 billion market cap. Popular indices such as the SPDR S&P 500 ETF (SPY), the PowerShares QQQ (QQQ), and the iShares Russell 2000 ETF (IWM) are all examples of capitalization weighted strategies. An investor not interested in seeking outperformance or alpha over a benchmark should always choose a capitalization-weighted index for the majority of their exposure due to their low cost, high liquidity, and low turnover. (For more, see: Guide To ETF Providers.)
ETFs and Equal Weighting
While capitalization weighting may have been one of the original indexing techniques, equal weight wasn’t far behind. Equal weighting an index essentially removes any enterprise value adjustments or other value considerations and simply allocates its constituents equally across the board. Although it doesn’t seem like a large alteration, in real-world practice it produces very different results. This is primary due to an outsized weighting toward smaller companies, and lighter weighting toward larger companies within the underlying index.
With a larger tilt toward smaller companies, investors should expect higher volatility when market corrections occur, but also a margin of outperformance during strong uptrends. Equal weight indices are best suited for younger or more aggressive investors seeking a larger allocation to up and coming companies within an index such as the S&P 500. The Guggenheim S&P 500 Equal Weight ETF (RSP) is an example of a popular equal weight strategy.
Beta Indexed ETFs
Marking the second evolution of the ETF, smart beta indexes created a new set of products targeted toward specific themes or investment strategies. Smart beta indexes are designed to quantitatively analyze companies across industry groups which have commonality such as trading activity, dividends, management, or corporate actions. While these indexes often times are aptly diversified and could be used as core holdings, they typically excel when they play a specialized role in a portfolio. Examples of such themes include indexes which group stocks based on low volatility, high dividends, share buybacks, or momentum.
These various strategies can complement market capitalized ETFs effectively by allowing you to overlap or overweight areas you feel will add value in the current market environment. Smart beta indexes are great tools for the majority of investors, but be sure to pay close attention to the number of holdings, expenses, and rebalancing rules to avoid common pitfalls of overly expensive or non-diversified strategies.
Fundamentally Weighted ETFs
Finally, the relative newcomers to the ETF universe include fundamentally weighted indexes which are designed to screen a specific group of stocks by capital strength, growth, value, or some other balance sheet statistic. In the same vein as market-cap weighted ETFs, the highest ranked or “strongest” companies within the index typically garner the largest allocation size.
Envision it this way; although Apple Inc. might be the largest company within the technology ecosphere, there are many companies that offer higher earnings growth, or price to book ratio, which could earn them a higher ranking in a fundamental index. The First Trust NASDAQ Technology Dividend Index Fund (TDIV) uses a modified dividend weighting methodology that builds off these principles.
It’s key to remember that often times a company that is most fundamentally sound isn’t always the largest within an industry group. In many indexing studies, this is the principle flaw that fundamental indexes are seeking to overcome.
While fundamental indexes are appropriate for all investors, it’s important to keep in mind that they often times carry a higher percentage of active share, which is a measure of a portfolio’s correlation to a benchmark index. In turn, many fundamental indexes have vastly outperformed their traditional market cap weighted benchmarks over the years. However, because of this deviation they also stand the chances of underperforming them in the future. For this very reason fundamentally weighted indexes should be reserved for those investors with the inclination and experience to evaluate the fund’s holdings and screening methodology.
The Bottom Line
Understanding the security selection and asset allocation technique that your ETF employs is one of the most powerful drivers of total return. The transparent nature of ETFs allows you to fully examine these characteristics and select a holding based on your risk tolerance, investment objectives, or fundamental outlook. In addition, new ETFs are consistently being introduced that offer innovative methodologies or risk-managed strategies that may be attractive in varying market environments.
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Disclosure: At the time this article was published, principals and clients of FMD Capital Management held positions TDIV.