How are securities in ETFs weighted?

An index is a group of securities chosen to represent an unbiased view of the risk-reward attributes of a market or a portion of a market.

Vanguard believes that because of this, indexes should be constructed according to the market capitalization of the underlying constituents.

In other words, Vanguard believes a true market index should reflect what the market actually is—investors' aggregate holdings of all individual securities in the market. An index that represents the entire market would comprise all publicly traded shares of each company, and by doing so it would naturally be market-cap-weighted. Companies whose shares accounted for the largest market value would have a larger weighting in the index.

 

Market capitalization: The traditional weighting methodology

For equity market indexes, weighting securities according to their market capitalization is the most commonly used method. Market-cap-weighted indexes reflect the consensus estimate of each company's value at any given moment. In any open market, new information—economic, financial or company-specific—affects the price of one or more securities and is reflected instantaneously in the index via the change in its market capitalization.

 

Alternative weighting methodologies

During the first decade of their existence, most ETFs were based on traditional market-cap-weighted indexes. Over time, a small minority of the investment community criticized the use of market-cap-weighted indexes based on perceived inefficiencies. This led to a proliferation of ETFs based on alternative strategies such as equal weighting and fundamental weighting. Sometimes called "smart beta" or "alternative indexing," our analysis has shown that these strategies:

• Are best described as rules-based strategies that make active bets by focusing on a small number of factors. Thus, Vanguard believes they should be evaluated as active investments.
• May not successfully capture market inefficiencies consistently across time.
• Have weighting differences versus market-cap-weighted indexes, demonstrating systematic tilts over time toward smaller-cap stocks or value stocks, or both.

Here are four strategies that use an alternative weighting methodology:

Equal-weighted	These strategies give an identical static weighting to each security, so that every stock in the targeted index has the same impact on returns. Compared with a market-cap-weighted portfolio, an equal-weighted portfolio will be more heavily concentrated in smaller companies and, to some extent, in companies trading at low prices relative to their book values.
Dividend-weighted	Investment providers are offering strategies that weight stocks based on current or expected dividend payments. These strategies can differ significantly from market-cap-weighted indexes. Because companies that pay dividends tend to be larger and have value traits, dividend-weighted strategies tend to overweight the large-cap value segment of the market.
Fundamental-weighted	Another approach is to weight companies based on fundamental measures such as earnings, revenue, assets, and book value of equity. The performance attributes of these strategies often demonstrate clear size and style tilts toward smaller-cap and value-oriented stocks.
Alternative fixed income indexing	Common alternative-weighting criteria for fixed income include gross domestic product, population and other macroeconomic measures for sovereign debt and assets, revenue, and other financial statement metrics for corporate issuers. These strategies tend to favor countries and companies with lower debt ratios.

 

The bottom line: Market-cap versus alternative weighting methodologies

A market-cap-weighted index is an "all-factor" index. That's because unlike alternative indexes, it reflects every possible factor that an investor can use to estimate a company's value. Market-cap-weighted indexes represent a true multifactor approach to investing.