Watch Your Weightings When Investing in Index Funds

Question: I invest in an S&P 500 index fund, which I know weights companies by their market value. What are some other weighting methods used by index funds?

Answer: Index funds have become an increasingly popular choice for investors, representing nearly 15% of all mutual fund assets today. All told, about $1.3 trillion is invested in U.S.-based index mutual funds, with a comparable amount invested in index-based exchange-traded funds.  

The core belief behind index investing is that beating the market consistently over the long term through actively picking stocks that will outperform is, to put it mildly, extremely difficult. Instead, the most basic index funds seek to capture the market's performance itself in the belief that the investors who participate in it are fundamentally rational and also value stocks at or near their fair values.

The first index fund, introduced by Vanguard in 1976 (an occasion marked by this anniversary piece by Morningstar's Dan Culloton last August), tracks the S&P 500, and today that index is by far the most popular one used, accounting for about 37% of all index fund assets. Since then hundreds of index-based mutual funds and ETFs have been introduced, tracking everything from companies that mine platinum (First Trust ISE Global Platinum Index ETF (PLTM)) to the Malaysian stock market (iShares MSCI Malaysia Index ETF (EWM)). There are funds that track the entire U.S. stock market ( Fidelity Spartan Total Market Index ) or the entire bond market ( Vanguard Total Bond Market Index (VBMFX)). In some cases, if an index is too broad or securities in it too illiquid for a fund to adequately track, the fund's manager might try to mimic the index's performance through a technique called representative sampling. Funds tracking the Barclays Capital Aggregate Bond or Russell 2000 indexes are examples of this.

But even though index funds seem to track anything and everything, there are a few primary ways of constructing them, from conventional market-cap weighting to alternative methods such as equal, fundamental, or price weighting. Let's take a closer look at these structures, along with the pros and cons of each.

Cap-Weighted Indexing
How it works: By far the most common method of indexing is through market-cap weighting, in which the amount of each stock held is proportionate to its market value, or capitalization. So if a stock's market cap makes up 5% of an index, it also makes up 5% of the fund's portfolio. 

Pros: The method provides an accurate reflection of how the market looks, with greater emphasis on bigger companies (by cap weight) and less on smaller companies; as stocks grow, they naturally take on a larger percentage of the index without the fund needing to buy new shares, making this method cheaper and more tax-efficient than others.

Cons: In rising markets, the index might include a higher percentage of overpriced stocks. The method emphasizes the biggest companies, which might have less room to grow than the smaller companies that make up less of the index.

Equal-Weighted Indexing
How it works: All stocks are held in equal proportion regardless of market cap. So, for example, an equal-weighted S&P 500 fund would still include the same 500 stocks as the cap-weighted version, but in equal amounts--in this case each making up 0.2% of the index.

Pros: The method provides a greater tilt to midsized companies, which sometimes offer better returns than the largest companies. 

Cons: By overweighting smaller companies, the index no longer accurately represents the market. The portfolio must be rebalanced periodically--typically quarterly--which creates transaction costs and means the index might fall out of equal-weighting for months at a time. Equal-weighted funds are generally more expensive than cap-weighted index funds.

Fundamental Indexing
How it works: Stocks are weighted based on a fundamental metric or metrics, such as dividend yield, earnings, book value, or a combination of factors. 

Pros: The method can be used to provide a tilt to an index (toward value or income, for example) while generally avoiding the negative effects of stocks becoming overvalued by the market. 

Cons: Fundamental indexing does not serve as a proxy for the market. It requires rebalancing that can add transaction costs, and funds that employ this method tend to be more expensive than cap-weighted index funds.

Price-Weighted Indexing
How it works: Stocks are weighted by the share price for each company in the index, with the Dow Jones Industrial Average the most famous example.

Pros: The method requires less trading than equal-weighted or fundamental indexing methods, which helps reduce costs. 

Cons: The index can become skewed toward overpriced stocks and detached from market values.

A Quick Comparison 
Now that you know how different index funds are weighted, you might be wondering how these approaches have performed relative to one another. For the sake of comparison, let's look at ETFs that track the S&P 500 (or an approximation) using three of the weighting methods described above. We'll look at three- and five-year annualized returns (the non-cap-weighted selections haven't been around long enough for a 10-year comparison) and include current fees to get a sense of the cost differences among the funds.

Cap-Weighted
 iShares S&P 500 Index (IVV)
3-year: 19.27%
5-year: 0.98%
Fees: 0.09%

Equal-Weighted
 Guggenheim S&P 500 Equal Weight (RSP)
3-year: 23.51%
5-year: 1.84%
Fees: 0.40%

Fundamental-Weighted (Earnings)
Wisdom Tree Earnings 500 (EPS)
3-year: 19.17%
5-year: 1.22%
Fees: 0.28%

As you can see, the equal-weighted index clearly outperformed the other two. This reflects the fact that mid-caps (and small-caps) outperformed large caps during the given time periods, so by having those stocks represent a larger share of its portfolio, the equal-weighted ETF outperformed. Will this always be the case? Not necessarily. In particular, when large caps lead the market, the equal-weighted index is likely to lag. Fundamental-weighted index funds are a bit trickier to predict given the many different ways they can be sliced and diced.

Whatever type of index fund or funds you choose, make sure you understand the methodology along with the pros and cons, so you don't get stuck with an investment that doesn't behave the way you expected.

Performance data as of April 13, 2012.

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