Which Indexing Strategy is Best?
By Ron DeLegge, Editor
January 25, 2010

SAN DIEGO (ETFguide.com) – Despite a push into active management, the ETF marketplace is still dominated by funds that follow indexes.

Many of these indexes follow traditionally constructed benchmarks whereas others use alternative methods. Let’s evaluate three main indexing strategies and find out which is the best.

Market Cap Weighting
Weighting securities by their market capitalization or market size is still the most popular and traditional method for index construction. Securities with the largest market size will dominate the performance of the index whereas smaller issues have less influence.

Widely followed benchmarks like the Nasdaq Composite (NYSEArca: ONEQ) and the S&P 500 (NYSEArca: SPY) follow a market cap weighted method. The Dow Jones Industrial Average (NYSEArca: DIA) does not use a market cap weighting method. Rather, it weights individual holdings by their stock price. Companies with the highest stock price will have the greatest influence on the DJIA’s performance.

Equal Weighting Strategies
Equal weighted indexes will typically own an equal share of securities. For example, the Rydex S&P Equal Weight ETF (NYSEArca: RSP) owns the same exact stocks within the S&P 500, but with a twist. Rather than weighting stocks by their market capitalization or size, RSP assigns each stock an equal weight of 0.20%. Each quarter the index is rebalanced to maintain its equal strategy. This minimizes the possibility of stocks with a large run up in their market value from dominating the indexes’ performance. 

Another version of equal weighting is with industry sectors. The ALPS Equal Sector Weight ETF (NYSEArca: EQL) owns an equal 11.11% share of the Select Sector SPDRs tracking the nine S&P 500 sectors.

An equal weighting index strategy will generally outperform traditional market cap weighted indexes over periods when mid and small cap stocks are in favor. This was the case in 2009 and RSP gained 45.03% whereas SPY which follows the traditionally constructed S&P 500 was ahead by 26.27%.

Fundamental Strategies
Instead of weighting stocks by their market size, fundamental indexes use screening factors like a company’s book value, dividend yield, revenues or other fundamental factors. The FTSE RAFI US 1000 index (NYSEArca: PRF), for example, essentially follows the same stocks contained within the Russell 1000. However, unlike the latter, it assigns a higher weighting to stocks with the best combination of book value, cash flow, sales and dividends.

Other ETF families like RevenueShares and WisdomTree use single financial factors like corporate revenue, earnings or dividend yield to weight index holdings. Although industry leaders like BlackRock (iShares), State Street Global Advisors (SPDRs) and the Vanguard Group mostly offer ETFs with a traditional market cap strategy, they too offer funds with fundamental weightings.

Conclusion
The idea that fundamentally weighted indexes are better or superior to traditionally constructed indexes is folklore. Each type of indexing strategy covered above has its own unique set of biases which may or may not work depending on a given market cycle. For example, fundamental indexes with a value bias will tend to outperform when value stocks are in vogue. Conversely, market cap weighted indexes, which don’t have a value bias will probably underperform. However, during a bull cycle for growth stocks, it’s just as likely a market cap weighted benchmark will beat a fundamental one. Likewise, equal weighted indexes will probably outperform when mid and smaller stocks are hot.

Love them or hate them, market cap indexes still represent the market’s performance. Even though they may not necessarily be perfect, they don’t have to be. Through both bull and bear markets, mutual funds and ETFs that follow market cap indexes continue to outperform most actively managed funds. What's so wrong with that? 

Lastly, here’s one final suggestion about the “better” indexing strategy; don’t be tricked by historical performance. Just because a dividend or value weighting strategy may have worked in the past, doesn’t mean it’ll work indefinitely into the future.

Over the long run, a traditional market cap weighted index will do just fine, which should be good enough, even for the most demanding investor.