Indexing

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.