Several common weighting types for index ETFs (1)

by ETF May. 27,2023
Several common weighting types for index ETFs (1)

An index ETF, in addition to looking at what the constituents are in it, we usually look at the position. This position setting is the weighting set in the indexing scheme.

 

Common types of weights are the following.

 

1. Market Cap Approach

As the name implies, the index's weight allocation is determined by the size of the market capitalization of its constituents, with the larger the market capitalization, the greater the company's share of the portfolio It is now the dominant weighting method. The theory is based on the "efficient market theory": the share price correctly reflects the price of the asset.

 

Pros: The most traditional approach, theoretically lower volatility and risk due to a bias towards large-cap stocks.

 

Cons: When the market is "invalid", valuations based on market capitalization-weighted indices can be unreasonable. The more overvalued a stock is, the higher its market capitalization and weighting may be, while the opposite is true for undervalued stocks. According to the theory of mean reversion, this will drag down the return of the portfolio.

 

Market capitalization-weighted indices are more influenced by the Momentum (MOMENTUM) factor.

 

Free floating market capitalization is the number of shares available for public trading, not including the number of shares held by controlling shareholders who are unwilling to sell, such as Berkshire. The shares outstanding will be deducted from the shares held by Buffett and other major shareholders. The calculation also usually subtracts the shares held by the government and the parent company, and the shares not open to foreign investors, called the free float.

 

The free float market capitalization weighting makes more sense from a tradability and liquidity perspective.

 

 

2.Equal Weighting Method

Equal weighting of the index means that each stock is given the same weighting in the index.

 

Benefit: The method is implicitly mathematically and financially sound. By allocating all stocks according to equal weighting, the index theoretically allocates overvalued and undervalued stocks equally, such that the undervalued and overvalued Hedging against each other will eliminate valuation bias to some extent.

 

Cons: Equal-weighted ETFs move more in favor of mid- and small-cap stocks, which can increase overall volatility. Theoretically, to keep the stock members of an equal-weighted index always equally weighted, index managers need to always be buying and selling those Stock Adjustment Position Weighting. Excessive trading can lead to excessive transaction costs, which can pull down investor returns. (In practice, periodic rebalancing is often done to avoid cumbersome and high turnover rates.)

 

Market cap weighted indexing is more of a "stronger is always stronger" investment philosophy, while equal weight indexing is closer to Yu believe that there is a cycle and rotation of sectors and individual stocks. It has been argued that equal-weighted indices, based on historical data, have been able to outperform market-capitalization weighting over the long term, and that, in addition to the influence of size factors, this Differences in investment philosophy also play an important role.

 

It has also been argued that the main reason that equal-weighted indices theoretically earn higher returns than market capitalization-weighted indices is that equal-weighted indices assume the The risk is higher, and this risk comes mainly from liquidity (Liquidity) and volatility ( Volatility. It is the principle that the return on investment is only as high as the risk taken by the investor and reflects the principle of market efficiency.

 

In practice, such an allocation is very popular in bull markets, but there is a possibility of greater retreat in bear markets. In the U.S. stocks for a decade long bull, S&P 500 equal-weighted RSP won the market capitalization-weighted SPY.

 

3.Tiered Weighting Method

The fundamental weighting method is to pick stocks and allocate weights based on a company's fundamentals, and the best way to do this is by Research. Affiliates has developed a valuation method called RAFI, which uses four dimensions to evaluate a company. The four dimensions are: book value, revenue, cash flow ( (cash flow) and dividends (dividends).

 

Advantage: This method of distribution is theoretically better at picking good, promising stocks.

 

Cons: Treating dividends as one of the four elements of valuation can lead to an imbalance in value; by focusing too much on revenue, the portfolio may be skewed toward low-margin or high-debt companies.