Individual Stocks vs. Exchange-Traded Funds
Traditional indexes still dominate, but alternative methods chipping away
The rapid expansion of the exchange-traded fund (ETF) marketplace has spurred innovation along with conflicting philosophies about the best way to assemble and manage stock market indexes.
While traditional indexes which weight stocks according to the size of their market capitalization still dominate the investment landscape, both fundamental and equal-weighted indexing strategies have emerged. Let�s briefly review each.
Traditional Market Cap Weighted Indexes
The basic tenet of classic or traditional indexing is to eliminate the risk of market underperformance by closely tracking stock indexes with the lowest possible costs. The largest companies within a market cap weighted index will typically have the greatest impact on the performance and volatility, whereas small companies have less influence.
| Traditional Market Cap Weighting | Fundamentally Weighting | Equal Weighting | |
| Screens stocks by dividends, earnings, and valuation metrics? | No | Yes | No |
| Companies with the largest market size have the greatest impact on the performance and volatility of the index? | Yes | No | No |
| Equally weights stocks within an index? | No | No | Yes |
| Popular stock indexes that follow these strategies? | DJ Wilshire 5000, S&P 500, Russell 2000 | FTSE RAFI U.S. 1000, WisdomTree Dividend Index | S&P Equal Weight Index, S&P Equal Weight Health Care |
Source: ETFguide.com
Many widely followed indexes such as the DJ Wilshire 5000, Russell 2000, and S&P; 500 follow a market cap weighted formula.
The iShares, State Street Global�s SPDRs, and Vanguard�s ETFs tend to favor this classic weighting methodology.
Potential Advantages:
-Low portfolio turnover of index components
-Market determines weighting of each component
Potential Disadvantages:
-Could underperform alternative weighted indexing strategies
-Under-represents stocks with smaller market capitalizations
Fundamentally Weighted Indexes
Fundamental indexes attempt to outperform classic benchmarks by screening securities based upon financial measures. Some of these metrics include sales, book value, cash flow, valuation and even dividends. Many of these indexes tend to have a value bias or tilt, which probably explains their strong performance when value stocks are in favor.
One of the most prominent fundamental indexes is the FTSE RAFI U.S.1000. It selects the largest U.S. stocks based upon a company�s fundamental measures: book value, income, sales and dividends. The 1000 equities with the highest fundamental strength are weighted by their fundamental scores. The fundamentally weighted portfolio is rebalanced and reconstituted annually. Other index versions of the FTSE RAFI methodology follow specific industry sectors, midcap stocks and international equities.
Many ETFs issued by Claymore, First Trust, PowerShares, and WisdomTree Investments follow a fundamental indexing strategy.
Potential Advantages:
-Reduces exposure to stocks with the highest market capitalization
-Alternative satellite position to pure active management
Potential Disadvantages:
-Could underperform traditional market cap weighted indexes
-Value or dividend bias in the index construction is out of favor
-Higher investment costs
Equal Weighted Indexes
Equal weighted indexes offer an interesting alternative for investors not entirely convinced by either traditional or fundamental indexing. In an equal weighted index, stocks are assigned the same weighting or representation, regardless of their market size, financial metrics or other factors.
For example, the S&P; Equal Weight index has the same holdings as the cap weighted S&P; 500, but each company is assigned a fixed weight of 0.20 percent and rebalanced quarterly. This indexing strategy prevents stocks with the largest market size from dominating the index.
Equal weighted indexes tend to outperform when mid and small cap stocks are in favor. In contrast, they are most likely to underperform when large company stocks are hot.
Another consideration is transaction costs. Since equal weight indexes tend to rebalance more frequently than market cap indexes, trading costs can add up.
Most index ETFs that have a pure equal weighting are offered by Rydex Investments.
Potential Advantages:
-Reduces exposure to stocks with the highest market capitalization
-Alternative satellite position to pure active management
Potential Disadvantages:
-Could underperform when large stocks are in favor
-Higher investment costs
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