With the size of the exchange-traded product market expanding rapidly each year, it is important for advisors to understand exactly what they are purchasing.

When thinking about choosing an ETF, typically the first step is to determine which investment universe you want to gain exposure to. This is usually pretty straightforward. You can choose exposure by size/market capitalization -- typically micro-cap, small-cap, mid-cap and large-cap -- then select domestic or foreign equities and level of economic development (developed, emerging or frontier markets). Investors can also get as granular as choosing individual sectors, countries, or regions.

You may want to further limit the asset class by style: value stocks (cheap, and most often mature stocks), growth stocks (expensive, and most often still innovating), or some combination of both.

However, once this step has been accomplished, many advisors overlook -- or at least underanalyze -- what I would consider an equally important characteristic: the way in which the equities are weighted within the ETF.

WEIGHTING STRATEGIES

A study done by Cass Consulting examined several alternate weighting schemes formed using the largest 1,000 equities in the U.S. stock market from 1969-2011. The purpose of the study was to illustrate the different impacts that various weighting methods can have on performance and volatility.

The most common form of index weighting used today is weighted by market cap: The weight of each stock is equal to its market capitalization divided by the sum of the market capitalization of all of the stocks in the index.

Cass also looked at other weighting systems: It constructed the dividend-weighted index by dividing the five-year average total dividend payout for each stock by the five-year average total dividend payout of all stocks to obtain the weight for each company, for instance. It used the same procedure for total annual cash flow, book value, and total annual sales to calculate those indices as well.

It also created a “fundamentals” composite-weighted index, incorporating the average cash flow weight, dividend weight, book value weight and sales weight of each company in the index, as calculated individually above. The weight in the composite index would be an average of these four metrics.

Surprisingly, market cap-weighted strategy -- the most popular methodology, and the one used by the massive SPDR S&P 500 ETF (SPY) -- was the worst performer in the study above. When purchasing a market cap-weighted index, you are investing more in overvalued companies and less in undervalued companies.

As shown by the study above, a weighting system based on fundamental factors that are tied to accounting measures, such as sales or earnings, could potentially provide superior returns. Even an equal-weighted index tends to outperform the popular market cap-weighted index.

AVAILABLE OPTIONS

In the ETF marketplace, many of these new weighting methodologies exist and are available for investment. Below are some examples for several of the aforementioned categories:

  • Equal-weighted: Guggenheim S&P 500 Equal Weight ETF (RSP)
  • Revenue-weighted: RevenueShares Navellier Overall A-100 Fund ETF (RWV)
  • Earnings-weighted: WisdomTree Earnings 500 Fund (EPS)
  • Dividend-weighted: WisdomTree Total Dividend Fund (DTD)
  • Dividend-weighted: WisdomTree U.S. Dividend Growth Fund (DGRW)
  • Fundamentals composite-weighted: First Trust Large Cap Core AlphaDEX Fund (FEX)
  • Fundamentals composite-weighted: PowerShares FTSE RAFI US 1000 (PRF)
  • Volatility-weighted: PowerShares Low Volatility (SPLV)
  • Volatility-weighted: iShares All Country Minimum Volatility (ACWV)
  • Momentum and Trend-weighted: PowerShares DWA Technical Leaders (PDP)
  • Beta-weighted: PowerShares S&P 500 High Beta (SPHB)
  • Beta-weighted: Russell 2000 Low Beta ETF (SLBT)

There is a lot to choose from in the ETF market place today and it helps to know the details of each investment before committing you or your client’s hard-earned capital. Once you understand what’s under the hood of your investment vehicle, you will be better equipped to adapt to different market environments and adjust portfolios accordingly.
Aaron Gilman, CFA, CFP, is chief investment officer at Independent Financial Partners in Tampa, Fla.