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 and bond market indexes.

Even though traditional indexes, which weight stocks and bonds according to the size of their market capitalization, still dominate the investment landscape, both fundamental and equal-weight index strategies have emerged.

Let’s briefly review each.

Traditional Index Investing

The basic tenet of classic or traditional indexing is to eliminate the risk of market underperformance by closely tracking stock and bond indexes with the lowest possible costs. Stocks with the largest market size within a market cap weighted index will typically have the greatest impact on performance and volatility whereas mid and small cap companies have less influence.

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 under perform alternative weighted indexing strategies
• Under-represents stocks with smaller market capitalizations

Fundamental Index Investing

Fundamental indexes attempt to outperform classic benchmarks by screening securities based upon various 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 passively selects the largest U.S. stocks based upon a company’s fundamental measures: book value, income, sales and dividends. After the stocks have been selected, companies 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 when value or dividend bias in the index construction is out of favor
• Higher investment costs

Equal Weighted Index Investing

Equal weighted indexes offer an interesting alternative for investors not entirely convinced by either traditional or fundamental indexing. In an equal weighted index, securities 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 0.2% and rebalanced quarterly. This indexing strategy prevents stocks with the largest market size from dominating the index.

Equity 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 strong gainers.

Another consideration is transaction costs. Since equal weight indexes tend to rebalance more frequently than market cap indexes, trading costs can add up.

Rydex Investments offers a series of ETFs with an equal weight index strategy.

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 cost

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