Smart Beta Investing: Index Construction and Methodology

While market cap is an important metric, it is just one of several that investors need to weigh in developing a well-balanced portfolio that outperforms the broader market. In a volatile global economy characterized by weak growth and uneven yields, alternative index construction has emerged as one of the central aspects of successful ETF investing.

Smart beta index construction attempts to address and overcome the main shortcomings of capitalization-weighted indices. Over the past four decades, market cap–weighted indices have emerged as the preeminent method of assessing the performance of the equity markets. This method is advantageous in that it provides a broad benchmark in which to compare the market, promotes diversification and is relatively inexpensive to track. A prominent example of a market cap index is the Nasdaq 100 Index, tracked by PowerShares QQQ ETF (QQQ B+).

Despite their advantages, indices that rely too heavily on market cap face several drawbacks. The first is risk of concentration. In such a weighting approach, large companies account for a bigger portion of the index. The same risk applies to indices that provide exposure to multiple countries and sectors. Too much concentration in one company, country or sector could have adverse effects on the broader index. Second, market cap schemes also tend to be backward-looking in that the shape of the index is driven largely by its past performance. Third, market cap–weighted indices are susceptible to mispricing.

At their worst, they are prone to bubbles since they reflect the full impact of asset price bubbles when they do arise. Common behavioral biases that are associated with market cap–weighted indices include momentum bias, which often leads to recency, as well as salience and selective perception.

Market cap isn’t the only weighting method ETF investors rely on to construct their indices. There are several alternative methods that have been shown to provide equal or greater success in today’s market. These include price-weighted, equal-weight and fundamental-weighted methodologies.

In a price-weighted index, individual stocks influence the performance of the index in proportion to their price per share. Under this method, indices derive their value by adding the prices of each individual stock and dividing them by the total number of stocks in the index. This method gives stocks with a higher price more weight, which translates into stronger influence over the performance of the index.

The Dow Jones Industrial Average is a prime example of a price-weighted index. The Dow’s main advantage is longevity, having withstood the test of time for more than a century. It also contains 30 of the most widely known blue-chip companies in the United States, which make the index less prone to volatility. Another prominent price-weighted index is Japan’s Nikkei 225 Index.

The main drawback of a price-weighted index is the lack of consideration given to the size of each stock’s industry or its underlying market capitalization. As the Dow demonstrates, 30 companies are a very narrow slice of a market with over 10,000 publicly listed stocks. Common behavioral biases associated with this methodology are overconfidence and selective perception.

Instead of tilting toward larger companies, equal-weight index construction assigns the same weighting across the board. A prime example is the S&P 500 Equal Weight Index, which assigns a 0.2% weight to each of its 500 components. The index rebalances on a quarterly basis to account for market fluctuations. Examples of ETFs using this methodology include the Guggenheim S&P 500 Equal Weight ETF (RSP A-) and the PowerShares Russell 2000 Equal Weight Portfolio (EQWS B-).

Research has shown that the equal-weight index methodology tends to outperform the market cap method in conditions that favor mid- or small-cap stocks. Small capitalization is a well-known factor used in smart beta investing, making the equal-weight method especially useful for this approach.

One drawback of equal-weight indices is they are more prone to cyclical risks, which tend to impact small-cap stocks more severely than larger companies. This form of index construction is also prone to the behavioral biases of stereotyping, anchoring bias and the ostrich effect.

Fundamental-weighted or fundamentally based indices are less conventional than the other methodologies. Such an approach weighs individual stocks based on fundamental factors such as revenue, quality, dividend yield, earnings per share, book value, number of employees and others. This methodology attempts to overcome the overweight-overvalued and underweight-undervalued stocks that typically comprise market capitalization–weighted indices.

Naturally, this methodology allows investors to cut across the simplistic formulas used in market cap and equal-weight strategies. On the downside, however, fundamentally weighted indices often blur the line between passive investing and active investing, which could undermine the successful management of a portfolio. Fundamental investing is also prone to information bias and choice-supportive bias.

Smart beta investing strategies that rely on value and quality factors may benefit from fundamental-weighted index construction. In this vein, fundamentally weighted indices may exhibit a correlation between economic performance and the asset’s return. This method of indexing often leads to the behavioral biases of stereotyping, information bias and the bandwagon effect.

A common index designed to utilize fundamental measures is the Russell Fundamental US Large Company Index. ETFs that track this index include the Schwab Fundamental US Large Company Index ETF (FNDX A). The FTSE RAFI US 1000 Index is also designed to track fundamental measures of firm size. ETFs that track this index include the PowerShares FTSE RAFI US 1000 Portfolio ETF (PRF A-).

For a deeper analysis of individual ETF investments like the ones discussed above, use our ETF Analyzer Tool. You can select ETFs by Category or Type as well as add individual ticker symbols to compare performance, expenses, and dividend yield among other metrics.

To learn more about the role of behavioral biases in index construction, take a look at “How to Battle Your Investing Biases.”

While there is no one-size-fits-all approach to smart beta investing, index construction that diversifies away from traditional market cap approaches is critical to navigate a volatile market cycle, making price-weighted, equal-weighted and fundamentally weighted strategies important to consider.

Smart beta funds have exploded in recent years, both in terms of total assets and investor adoption. To find out more about individual factors associated with smart beta, read “Smart Beta ETFs Can Help You Navigate The Market Cycle.”

For more ETF news, analysis and resources, subscribe to our free newsletter.