Two alternative ways investors can track the market

interactive investor’s ETFs expert explains the different ways ETFs can track the market, how it affects the way they move and why it’s important to you.

An index is a sample of stocks, designed to act as a gauge for the overall health and direction of a market. For example, the S&P 500 is a sample of some of the 500 largest stocks in the US, so is seen as a barometer for how the US market is doing overall. Likewise, any investor who wants exposure to US stocks will likely buy an exchange traded fund (ETF) tracking the S&P 500 index.

Such indices are usually constructed using a market capitalisation-weighting. This means that the size of each company in the index, and their influence on its movements, is based on their market capitalisation relative to other constituents.

So, for instance, if Apple (NASDAQ:AAPL) is 7% of the S&P 500 that is because Apple’s market cap is equal to 7% of the entire combined market cap of all S&P 500 constituents. If Apple’s share price goes up compared to other members of the index, so too would its market cap and, therefore, how much of the index it represents.

This is the most popular way of tracking an index. Generally, advocates of ideas such as the Efficient Market Hypothesis prefer market cap-weighting indices owing to their belief that markets are generally quite good at correctly pricing stocks.

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However, market cap-weighted indices also have some supposed weaknesses. One such criticism is that they include more of what has already gone up – yesterday’s winners dominate the index and, therefore, any portfolio tracking it.

For instance, five big tech companies in the US (Amazon (NASDAQ:AMZN), Apple, Alphabet (NASDAQ:GOOGL), Microsoft (NASDAQ:MSFT) and Facebook (NASDAQ:FB)), represent 1% of the 500 stocks in the index. However, due to their market-cap size they currently account for around 25% of the entire index on a market cap-weighting. This means that future performance of the S&P 500 is heavily reliant on the performance of these stocks.

Related to this is the concern that market cap-weighted indices, by design, over-represent the more expensive parts of the market and underweight what is cheap. For some, always having more money allocated to the more expensive stocks and less to cheaper stocks is a potentially bad way to invest.

As a result, some investors seek out alternatives to market cap-weighted indices. These indices, in theory, allow investors to track an index without suffering from some of the potential downsides of market cap-weighting.

Below, we explain other ways that indices can be weighted and note some of the ETFs that make use of these alternative indices.

Equal weighted indices

As the name suggests, stocks included in this index are each given an equal weighting. For instance, if an index has 100 members, in an equal weighted index each company would always account for 1% of the index.

The supposed advantage of this sort of index is that it doesn’t overweight past winners in the way market cap indices are said to. Instead, each stock is given the same weighting, regardless of past performance. This means equal exposure to potentially undervalued stocks in the same proportion of anything that’s overvalued. 

An example of an ETF tracking an equal weighted US index is Xtrackers S&P 500 Equal Weight ETF 1C GBP (LSE:XDEW).Another example is VanEck Global Equal Weight ETF GBP (LSE:TGGB), which instead tracks a global equal weighted index.

But there are a couple of potential downsides. First, such alternative indices have performed relatively poorly in recent years. For instance, data from FE Analytics shows that between the end of September 2010 and the end of September 2020, the S&P 500 has returned 315%, while the equal weighted version has returned 260%.

That makes sense. The past 10 years have been characterised by the persistent outperformance of a handful of expensive large-cap growth and tech stocks. The equal weighted index has suffered due to a lower exposure to some of the best performers of the decade – again, tech companies such as Apple and Amazon. 

However, the advocate of an equal weighted index would counter that the stronger performance of these companies will not last forever. If, or when, Big Tech’s performance does reverse, market cap indices will suffer much more than equal weighted indices, in theory.

But if an investor decides to now opt for an equal weighted index tracking ETF, but the strong performance of US tech continues for another five years, they may end up suffering underperformance for the next five years. Or, if the fortunes of US tech finally turn, their decision to use an equal weighted index may seem fortuitous – such things are almost impossible to predict.

Second, ETFs using a market cap-weighted index do not need to buy or sell stocks very often to keep mirroring the index. A change in price and market cap automatically results in a change in composition with no buying or selling involved. In contrast, equal weighted indices will have to regularly buy or sell to keep to the target weighting as the price of these stocks fluctuate. This creates extra costs for the investor.

The Fundamental Index

Another approach to weighting an index is to use the economic fundamentals of companies to decide their weightings. One of the leading advocates of this approach is Rob Arnott from Research Affiliates. Arnott is co-author of a book called The Fundamental Index: A Better Way to Invest, which outlines why this approach to index weighting is superior to market cap-weighting.

The Research Affiliates version of the Fundamental Index is called the Research Affiliates Fundamental Index, or RAFI. Specifically, the index weights companies by four main factors:

• Sales
• Cash flow
• Book value
• Dividends

The idea is that such metrics better capture the economic size of a company rather than just its market price. As Arnott notes in his book, “We chose these four metrics because they represent the most objective measures from each of the major ‘categories’ that people use to measure economic size.”

Throughout the book, Arnott cites research showing that his Fundamental Index outperforms market cap equivalents on multi-decade time frames.

This index is now tracked by a handful of ETFs. For example, the Invesco FTSE RAFI US 1000 ETF GBP (LSE:PSRF).

But again, the approach is not without its criticisms. A major issue with the Fundamental Index is that, like the equal weighted index, it has higher costs than a market cap-weighted index because it must be rebalanced and managed. For many index investors, controlling costs is one of the most important things an investor can do – so any index approach that results in higher fees is frowned on. Defenders of the approach, however, would say that potential higher returns should eclipse these concerns.

Another criticism of the Fundamental Index is that it is simply a tilt towards both “value” and small-cap stocks. The same is also often said of an equal weighted index. This means that investors end up with a higher exposure to “cheap” value stocks or smaller ends of the market, which, under certain conditions, perform better or worse.

Different indices perform better under different conditions

This brings us to a wider point about market-cap indices and the alternatives explained here, that they often perform better or worse under different economic or market conditions. Different indices tend to have different “factor” tilts – meaning they have a higher weighting to the sorts of stocks that respond in specific ways to the wider economic and market environment.  

As critics of the Fundamental Index note, by focusing on economic fundamentals over price, the index has a higher exposure to value stocks. However, whether this is necessarily a bad thing is open to debate. Academic literature has long shown that value stocks outperform over the long term.

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In certain market conditions, such as the past 10 years, this has not been the case – although many investors expect value stocks to start outperforming again eventually. That would, in theory, benefit the Fundamental Index, compared to its market cap equivalent.  

In contrast, a market cap-weighted portfolio, by design, is more likely to have exposure to “growth” stocks. Being driven by market price, a market cap index will favour companies with above-average growth expectations. It will generally have a higher weighting to companies trading on above-average multiples.

As a result, a market cap index performs better under conditions, such as in the past decade, when market and economic conditions have been more favourable to “growth” stocks. Should this continue, market indices will continue to perform best.

However, should the economic backdrop change (a return to higher inflation, for example), other indices, such as the Fundamental Index, may start to perform better.

Of course, knowing such things ahead of time is incredibly hard. At some point the trend for the outperformance of large-cap growth stocks, which has powered the performance of market cap indices for 10 years, will reverse. The problem is knowing when exactly this will happen.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.