3 Types of Indexing for ETF Success

The dominant driver of performance in an exchange-traded fund (ETF) is the index with which it is paired. If you can select the "best-fit" index for your personal needs, you are on the road to ETF success. However, deciphering indexes is one of the more demanding tasks in the investment field, and it is not getting easier. There are three dominant types of indexes to consider: market-cap weighted, equal weighted and fundamental.

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Indexing has become an innovation-driven science, and investor acceptance of new concepts has fueled a "great debate" about which indexing methods will produce superior performance over time. In this article, we will discuss key points in this debate, while comparing three genres of indexing: market cap weight, equal weight and fundamental indexing.

Defining Investment Performance
Investment indexes are designed to mirror the average performance of financial markets. For example, the most successful index in history is the Standard & Poor's 500 Index (S&P 500).

The S&P 500 index assigns 500 component stocks, a weight that reflects each stock's market capitalization and the total value of all shares of stock outstanding. One advantage of such a market-cap weighted index is simplicity. As stock prices change daily, the weightings of index components automatically adjust. (To learn more on indexes, see Don't Judge an Index by Its Cover and An Inside Look at ETF Construction.)

However, there are also drawbacks to this method, starting with a fairly heavy concentration in the largest stocks. As of Sept. 30, 2016, the top 10 stocks accounted for 18.1% of the S&P 500 index weight and performance, as shown in the table below:

Top 10 Components of S&P 500 Index by Weight (As of September 2016)

Many other leading U.S. equity indexes have similar market-cap weighting and top-heavy bias toward large companies. These include the Russell 1000 (RUI), Russell 3000 (RUA) and Wilshire 5000 Total Market Index (TMWX). Each of these indexes includes more components than the S&P 500, however, so their top 10 holdings represent less than 20% of their total market cap.

Market-cap weighted indexes are tilted toward large companies, therefore, they generally perform best when large-caps outperform mid- or small-caps. Also, these indexes perform well in momentum-driven markets. During the late 1990s bull market, the S&P 500 became heavily weighted toward tech stocks and, thus, became more vulnerable to the crash in prices that followed in 2000-2002. According to Standard & Poor's, the allocation of the S&P 500 Index increased from 11% in the technology sector at the start of 1995 to a peak of 34.3% in March 2000, followed by 21.2% in September 2016.

The Value of Equal-Weight Indexes
An alternative to a market-cap weighted benchmark is the Standard & Poor's 500 Equal-Weight Index. Instead of tilting towards the largest companies, this index assigns the same weighting to each of its constituents. For example, the S&P 500 gives a 0.2% weight to each of the 500 components and rebalances quarterly to adjust for changes in market values. An ETF that tracks this index is Guggenheim S&P Equal Weight (NYSEARCA:RSP).

An equal-weight index tends to perform better than a market-cap weighted index in environments that favor mid- or small-cap stocks. The equal-weight index also has the advantage of avoiding excessive valuations during momentum-driven markets.

Some investors believe the choice between a market-cap weighted index and an equal-weight index is minor. However, the performance difference can be surprisingly large. The broadest of all U.S. stock market indexes are published by Wilshire Associates and include more than 5,000 component stocks, which account for more than 99% of all U.S. publicly traded equities. The table below compares the performance of the equal-weight version of this index with the market-cap weighted version. Both versions hold the same components.

Performance of S&P 500 Indexes (For Periods Ending September 30, 2016)

Source: S&P Dow Jones Indices

The equal-weight 5000 index had superior long-term performance because longer periods are more favorable for small/mid-cap stocks. However, over the short periods shown, the trend reverses and large-caps returned to favor.

Rebalancing Cost Drag
Unlike the Russell, Dow Jones and Wilshire indexes, in which components are selected mechanically based on "quant" statistics, the S&P 500 is driven by a committee approach to stock inclusion and turnover. (For related reading, see Rebalance Your Portfolio To Stay On Track.)

Both market-cap weighted and equal-weight indexes of the same sponsors tend to change components at the same time. The difference is that the equal-weight indexes must be rebalanced back to the target weightings periodically, while the market cap weighted indexes are not rebalanced to correct for market price changes. Rebalancing generates a few basis points per year of cost drag in ETFs that track equal-weight indexes.

Fundamental Indexing Enters the Debate
Based on research conducted by Rob Arnott, chairman of Research Affiliates, a new concept in indexing was introduced in 2005 as a joint venture between the FTSE Group and Research Affiliates. The broad-based U.S. equity index FTSE RAFI 1000 selects 1,000 components based on a rules-based model that includes sales, cash flow, book value, and dividends. A fundamental index attempts to go beyond the concept of mirroring the experience of an "average investor," by selecting and weighting component stocks based on current and quantitative ranking of company data. (For more insight, read Fundamentally-Weighted Index Investing.)

When the FTSE RAFI 1000 was paired with a PowerShares ETF to form the PowerShares FTSE RAFI US 1000 (ARCA:PRF), it proved so popular with investors that PowerShares has since rolled out a large menu of fundamental ETFs. WisdomTree Investments and Claymore Securities also promoted the concept by launching ETFs tied to fundamental indexes.

The performance of the FTSE RAFI 1000 has provided an early test of how well fundamental indexes can perform vs. traditional market-cap weighted benchmarks. In the table below, actual performance (since 2005) is supplemented with hypothetical backtest data showing how the index hypothetically would have performed over the past 10 years.

Performance Comparison (For Periods Ending September 30, 2011)

Source: PowerShares

Based on this data, it appears that fundamental indexes occupy a middle ground between market-cap weighted and equal-weight indexes. They tend to track somewhat closer to market-cap weighted index performance over time while avoiding those indexes' large-cap bias and vulnerability to momentum-driven markets.

Research Affiliates contends that the benefit of fundamental indexing is in tempering portfolio risk, especially during momentum-driven markets. By selecting and weighting components based on company data, and periodically rebalancing the index to reflect new data, the fundamental index will tend to have a lower price/earnings ratio (P/E ratio) and less volatility than market-cap weighted indexes. Performance data also suggests that fundamental indexes may tend to overweight value stocks and underweight growth stocks relative to comparable market-cap weighted indexes. (For more, read A Guide To Portfolio Construction.)

Over long periods of time, Research Affiliates claims that fundamental indexing should produce a small, but meaningful, performance edge over market-cap weighted indexes. The firm's analysis shows that on a back-tested basis over 45 years, the FTSE RAFI 1000 hypothetically would have returned an annualized 12.5%, compared to 10.3% for the S&P 500's actual historical return.

The Bottom Line
For investors, perhaps the best way to learn more about any type of index is to allocate a portion of a portfolio to it via ETFs or index mutual funds and then track it against alternatives, over time.