Index methodology explained

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Why you should care about index methodology

The meteoric rise of the ETF industry has had the effect of transforming indices from hypothetical measures of performance into ‘investable assets’.

As indexing strategies continue to gain significant inflows from all types of investors, the scrutiny of construction and maintenance methodologies underlying indices (and the ETFs that aim to track those indices) has intensified considerably.

Here’s why it is important to care about index methodology.

Summary

  • Index weighting methodologies can have a significant impact on an ETF’s returns
  • Indices can be market cap weighted, equal weighted, fundamentally weighted, earnings-weighted, dividend-weighted indices and more
  • When considering allocating to an equity ETF, investors should focus not just on the asset class or universe of equities the ETF provides exposure to, but also on the methodology for the index that the fund seeks to track and whether that is consistent with their desired exposure

What is an index methodology?

Broadly speaking, an index methodology is a set of rules or criteria that govern an index’s creation, calculation, and maintenance. The rules determine the assets that are eligible for inclusion in the index, the formulas by which the index value is calculated, the process for modifying the components, and a timetable for updates.

The indices underlying many of the most popular equity ETFs are market capitalisation-weighted benchmarks, meaning that the companies with the largest equity values receive the largest portfolio weightings. But while the ETF industry has helped to reinforce the popularity of these indices – such as the S&P 500, S&P/ASX 200 and MSCI World – it has also given increased visibility to alternative weighting methodologies.

A number of issuers offer equity ETFs that seek to track indices that are not based on market capitalisation, including:

  • equal-weighted indices
  • earnings-weighted and dividend-weighted indices
  • indices where security weightings are based on top-line revenue, and
  • fundamental weighting methodology.

When allocating assets to equity ETFs, many advisers and investors focus primarily on the type of exposure desired, for example large cap domestics, small cap internationals etc.

However, the rules used to both select index components and allocate individual security weightings can also have a significant impact on the total return generated by an equity ETF.

Equal weighting methodology

The below table shows the performance of the S&P 500 Index compared to the S&P 500 Equal Weight Index for various time periods to 31 January 2021.

Source: Morningstar. Index performance does not take into account any ETF fees and costs. You cannot invest directly in an index. Past performance is not indicative of future performance of any index or ETF.

The holdings in the two indices are identical, but the S&P 500 employs a market cap-weighted approach whereas the S&P 500 Equal Weight gives an equal weighting to each security. That seemingly minor tweak resulted in a more than 186 basis point p.a. difference over the 20 years to 31 January 2021. With compounding, this equates to a cumulative total return of 310% (equal weight) compared to 189% (market cap-weighted) over the 20-year period.

Each methodology has both advantages and potential drawbacks, which have been evident in different market conditions (remembering that past performance isn’t indicative of future performance).

Market-cap weighting has typically outperformed an equal weight approach in periods of sustained price trends favouring the largest-cap stocks – such as during the last 5 to 10 years when mega-cap U.S. tech stocks have performed strongly. However, the equal-weight approach has tended to more than make up this lost ground when these price trends reversed – and the relative performance of large ‘hot’ stocks has reversed.

In any case, the figures above demonstrate that the weighting methodology selected can have a material impact on bottom line return.

QUS S&P 500 Equal Weight ETF aims to track the performance of the S&P 500 Equal Weight Index (before fees and expenses). Like the S&P 500 Index, it holds a portfolio of 500 leading listed U.S. companies, but gives an equal weighting to each (i.e. each stock makes up 0.20% of the fund’s assets upon each quarterly rebalancing).

That means there will be a reduced risk of QUS being heavily exposed to a small number of mega-cap stocks – for example, the top 10 holdings of the S&P 500 currently make up about 28% of assets, compared to just 2% for QUS (as at 31st January 2021).

Fundamental weighting methodology

Turning to an example in the Australian market, the below table shows the performance of the Solactive Australia 200 Index compared to the FTSE RAFI Australia 200 Index for various time periods to 31 January 2021.

Source: Morningstar. Index performance does not take into account any ETF fees and costs. You cannot invest directly in an index. Past performance is not indicative of future performance of any index or ETF.

The Solactive Australia 200 Index comprises the 200 largest companies by market capitalisation listed on the ASX. The FTSE RAFI Australia 200 Index is designed to track the performance of the 200 largest Australian companies as measured by fundamental size.

Whereas the Solactive Index relies on a market cap-weighted approach, the RAFI methodology uses a ‘fundamental score’ to compute stock. Stocks are selected and weighted based on four fundamental measures of size:

  • book value
  • cash flow
  • sales, and
  • dividends.

Again, as can be seen from the historical returns shown above, the weighting methodology has had a material impact on bottom line return.

The A200 Australia 200 ETF  aims to track the performance of the Solactive Australia 200 Index (before fees and expenses). It holds the 200 largest companies listed on the ASX by market capitalisation.

The QOZ FTSE RAFI Australia 200 ETF  aims to track the performance of the FTSE RAFI Australia 200 Index (before fees and expenses). The portfolio is weighted in a way that aims to reflect economic importance rather than the market capitalisation of its constituents.

Investing involves risk. The value of an investment and income distributions can go down as well as up. Before making an investment decision you should consider the relevant Product Disclosure Statement (available at www.betashares.com.au) and your particular circumstances, including your tolerance for risk, and obtain financial advice. An investment in any Betashares Fund should only be considered as a component of a broader portfolio.

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Written by

Patrick Poke

Content Director

Formerly Managing Editor at Livewire Markets. Passionate about investments, markets, and economics.

Read more from Patrick.