Exchange-traded funds (ETFs) based on indices are meant to be simple, transparent, cheap investment vehicles, which do not require the expertise (and thus avoid the cost) of an “active” fund manager. They instead simply buy exposure to the stocks (or bonds or commodities) in the particular index being tracked – so-called “passive” investing. And they do fulfil this role, pretty successfully in my view.
But when you delve into the indices upon which these ETFs are based, you find that there is a huge number of variations on this particular passive investing theme; it’s like opening a can of worms.
Weighting index members by market cap
For instance, the vast majority of benchmark stock indices that you will have heard of – like the S&P 500, FTSE 100 or Euro STOXX 50 – weight the stocks in their index by market capitalisation. That is to say, the more a particular company (e.g. Vodafone) is worth, the greater its weighting in the index, and thus the more of that company you will buy exposure to when you buy a FTSE 100 index ETF.
Concentration on a few stocks is not a good thing
But this is not necessarily the best way to construct an index. For one thing, you tend to concentrate a lot of your investment in just a few companies. For instance, the top ten companies in the FTSE 100 (including Vodafone, HSBC, etc.) account for over 41% of the index, while the top 20 count for nearly 62%. This situation is illustrated in the chart below.
So an investment in a FTSE 100 ETF is not spread over a broad spread of UK companies as you might expect, but instead is concentrating a lot of your ETF investment in a handful of banks, telecoms, and oil and gas producers.
The problems of weighting by market value
Academic research over the years has established that indices built on the basis of weighting by market value tend to suffer from two problems:
- Over the long term, they tend to underperform indices constructed in other ways (e.g. an equal-weighted index, which gives each company the same index weighting; or a fundamentally-weighted index, which calculates the weight for each company according to how cheap and how profitable it is); and
- In an index like the FTSE 100, you are taking more risk than you think, given that your portfolio is heavily skewed towards just a few stocks in only a few industries. Remember, diversification is one of the true “free lunches” that exist in investing, so you want to take full advantage of it!
You should look to invest in stock market index ETFs that are based on:
- Very broad indices like the FTSE All-Share rather than just the FTSE 100, so you are spreading your investment over more companies and industries, and
- A weighting system other than market value weighting, such as equal weighting or weighting by fundamental criteria – like valuation and profitability.
There are ETFs out there that can meet these requirements.
Alternatives to classic (market-capitalisation weighted) index ETFs
Based on fundamentals (like valuation and profitability)
- Europe: Lyxor ETF RAFI Europe
- USA: Lyxor ETF RAFI US 1000
Based just on valuation or dividend yield
- Europe (ex-UK): Lyxor MSCI EMU Value
- USA: Lyxor ETF Russell 1000 Value
Based just on growth
- Europe (ex-UK): Lyxor MSCI EMU Growth
- USA: Lyxor ETF Russell 1000 Growth