While much of the financial world is in a state of uncertainty that has left investors apprehensive, market darlings such as Apple have headed for the stratosphere.
In the world of indexing, the meteoric rise of Apple, Google and other technology companies has created a divergence between market-cap-weighted ETFs and their fundamentally weighted counterparts.
The divergence is growing too:Valuation multiples for select tech companies have expanded skyward and continue to comprise an ever-greater portion of market-capitalization-weighted ETFs and indexes.
Market-cap-weighted indexes, such as the S'P 500, and the ETFs that track them, increase the size of their holdings as the security itself becomes more expensive. So, as the share price of Apple Inc. (AAPL) increases, ETFs that track market-cap-weighted indexes buy more of it.
To some, this implies that the ETF is definitively "behind the curve," and begs the question, Is paying for popularity a sound investment tactic?
In contrast, fundamentally weighted funds use factors such as sales, cash flow, dividends and book value to determine relative weighting size.
To drive home the point, fundamentally weighted ETFs have actually reduced exposure to many of this year’s hottest tech companies at the same time as market-cap-weighted funds are boosting exposure and droves of investors are busy talking themselves into jumping into Apple before it’s too late.
Two popular funds that offer exposure to the same space make the point perfectly. They are:
- PowerShares’ FTSE RAFI US 1000 Portfolio (PRF), a fundamentally weighted fund with an index designed by Rob Arnott’s Research Affiliates that has assets of $1.45 billion
- State Street’s SPDR S'P 500 ETF (SPY), the first U.S.-listed exchange-traded fund and the biggest in the world, with assets of more than $118 billion
The first chart compares the two funds’ holdings at the start of this year and the latter chart compares them at the end of the third quarter of 2012.
The difference between the two underscores the distinction between fundamental and market-cap-weighted funds:While PRF has maintained weighting allocations in line with fundamentals, SPY has captured market optimism in its market-cap-weighted index.
A grounded comparison between the two is that fundamentally weighted ETFs pay for realized performance, whereas market-cap-weighted funds—because they are affected by price—tend to factor in optimism, or pessimism, about future performance.
To me, a comparison between the two weighting methods illustrates a deeper, more theoretical difference.
The efficient-market view is a popular one, and fans may appreciate market-cap weighting, as the theory goes, for inherently including "all known information" in a security’s price.
Investors who believe that markets are less than perfectly efficient may appreciate that fundamentally weighted funds are less subject to fluctuations in sentiment regarding a particular security and instead base their weightings on realized performance.
If you believe that the hype surrounding many of this year’s hottest tech companies will come to fruition, you may be partial to market-cap-weighted portfolios such as SPY’s, where top tech companies easily have the largest allocations.
If, however, you’re skeptical of the hype and prefer to maintain allocations in line with realized fundamentals, or simply prefer the smaller allocations to many of today’s "hottest" tech companies, then you may prefer fundamentally weighted funds such as PRF.
Ultimately, one weighting method is not necessarily better than the other, but if you believe that what goes up must come down, or that the mighty will fall, sticking to fundamentally weighted portfolios may better serve your interests.
At the time the article was written, the author had no positions in the securities mentioned. Contact Spencer Bogart at firstname.lastname@example.org.
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