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Index Methodology Explained

 

Why you should care about index methodology

The meteoric rise of the ETF industry has had the effect of transforming indices from hypothetical measures of performance into ‘investable assets’.

 

As indexing strategies continue to gain significant inflows from all types of investors, the scrutiny of construction and maintenance methodologies underlying indices (and the ETFs that aim to track those indices) has intensified considerably.

 

Here’s why it is important to care about index methodology.

 

 

 

Summary

Index weighting methodologies can have a significant impact on an ETF’s returns

Indices can be market cap weighted, equal weighted, fundamentally weighted, earnings-weighted, dividend-weighted indices and more

When considering allocating to an equity ETF, investors should focus not just on the asset class or universe of equities the ETF provides exposure to, but also on the methodology for the index that the fund seeks to track and whether that is consistent with their desired exposure

 

 

What is an index methodology?

Broadly speaking, an index methodology is a set of rules or criteria that govern an index’s creation, calculation, and maintenance. The rules determine the assets that are eligible for inclusion in the index, the formulas by which the index value is calculated, the process for modifying the components, and a timetable for updates.

 

The indices underlying many of the most popular equity ETFs are market capitalisation-weighted benchmarks, meaning that the companies with the largest equity values receive the largest portfolio weightings. But while the ETF industry has helped to reinforce the popularity of these indices – such as the S&P 500, S&P/ASX 200 and MSCI World – it has also given increased visibility to alternative weighting methodologies.

 

A number of issuers offer equity ETFs that seek to track indices that are not based on market capitalisation, including:

 

equal-weighted indices

earnings-weighted and dividend-weighted indices

indices where security weightings are based on top-line revenue, and

fundamental weighting methodology.

When allocating assets to equity ETFs, many advisers and investors focus primarily on the type of exposure desired, for example large cap domestics, small cap internationals etc.

 

However, the rules used to both select index components and allocate individual security weightings can also have a significant impact on the total return generated by an equity ETF.

 

 

 

Equal weighting methodology

The below table shows the performance of the S&P 500 Index compared to the S&P 500 Equal Weight Index for various time periods to 31 January 2021.

 

S&P 500 historical returns 31 January 2021

Source: Morningstar. Index performance does not take into account any ETF fees and costs. You cannot invest directly in an index. Past performance is not indicative of future performance of any index or ETF.

 

The holdings in the two indices are identical, but the S&P 500 employs a market cap-weighted approach whereas the S&P 500 Equal Weight gives an equal weighting to each security. That seemingly minor tweak resulted in a more than 186 basis point p.a. difference over the 20 years to 31 January 2021. With compounding, this equates to a cumulative total return of 310% (equal weight) compared to 189% (market cap-weighted) over the 20-year period.

 

Each methodology has both advantages and potential drawbacks, which have been evident in different market conditions (remembering that past performance isn’t indicative of future performance).

 

Market-cap weighting has typically outperformed an equal weight approach in periods of sustained price trends favouring the largest-cap stocks – such as during the last 5 to 10 years when mega-cap U.S. tech stocks have performed strongly. However, the equal-weight approach has tended to more than make up this lost ground when these price trends reversed – and the relative performance of large ‘hot’ stocks has reversed.

 

In any case, the figures above demonstrate that the weighting methodology selected can have a material impact on bottom line return.

 

The BetaShares S&P 500 Equal Weight ETF (QUS) aims to track the performance of the S&P 500 Equal Weight Index (before fees and expenses). Like the S&P 500 Index, it holds a portfolio of 500 leading listed U.S. companies, but gives an equal weighting to each (i.e. each stock makes up 0.20% of the fund’s assets upon each quarterly rebalancing).

 

That means there will be a reduced risk of QUS being heavily exposed to a small number of mega-cap stocks – for example, the top 10 holdings of the S&P 500 currently make up about 28% of assets, compared to just 2% for QUS (as at 31st January 2021).

 

 

 

Fundamental weighting methodology

Turning to an example in the Australian market, the below table shows the performance of the Solactive Australia 200 Index compared to the FTSE RAFI Australia 200 Index for various time periods to 31 January 2021.

 

FTSE RAFI aus 200 historical returns 31 January 2021

Source: Morningstar. Index performance does not take into account any ETF fees and costs. You cannot invest directly in an index. Past performance is not indicative of future performance of any index or ETF.

 

The Solactive Australia 200 Index comprises the 200 largest companies by market capitalisation listed on the ASX. The FTSE RAFI Australia 200 Index is designed to track the performance of the 200 largest Australian companies as measured by fundamental size.

 

Whereas the Solactive Index relies on a market cap-weighted approach, the RAFI methodology uses a ‘fundamental score’ to compute stock. Stocks are selected and weighted based on four fundamental measures of size:

 

book value

cash flow

sales, and

dividends.

Again, as can be seen from the historical returns shown above, the weighting methodology has had a material impact on bottom line return.

 

The BetaShares Australia 200 ETF (A200) aims to track the performance of the Solactive Australia 200 Index (before fees and expenses). It holds the 200 largest companies listed on the ASX by market capitalisation.

 

The BetaShares FTSE RAFI Australia 200 ETF (QOZ) aims to track the performance of the FTSE RAFI Australia 200 Index (before fees and expenses). The portfolio is weighted in a way that aims to reflect economic importance rather than the market capitalisation of its constituents.

 

https://www.sharecafe.com.au/2021/04/12/ind...logy-explained/

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from our own sharecafe

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Thanks for posting eb.

 

I prefer direct and active investments (including LICs). The proliferation of ETFs is no real help to anyone who thinks they're getting a simple answer to constructing a portfolio, as the various methodologies behind the ETFs indicates.

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ETFs listed in Australian held $102.8 billion in assets at the end of March, according to analysis of both Australian Securities Exchange and Chi-X data by ETF provider BetaShares.

 

The milestone comes after investors ploughed an additional $8 billion into ETFs in the first three months of 2021, taking the total investment to $46 billion in new money over the 12 months to March 31.

 

That represents an 80 per cent increase in flows on the previous year, which BetaShares concluded was the “most rapid growth over a 12 month period in the industry’s historyâ€.

 

However, that figure includes the major contribution of the Magellan Global Fund (MGF), which was converted from a closed-end fund to an ASX-listed active ETF in November last year. MGF is the largest individual ETF in Australia by market capitalisation with $13.6 billion in assets, almost twice the $7.7 billion held in the largest passively managed fund, the Vanguard Australian Shares Index ETF.

 

Nonethless, the ETF market’s upward trajectory looks set to continue. BetaShares forecasted total industry assets under management to grow by an additional 25 per cent by December.

 

 

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There are a number of readings telling us that the SPX is short-term stretched. We’ll review NINE of these below.

 

 

 

2

 

One is that the SPX’s 14-Day RSI now is overbought for the first time since early September.

 

 

 

3

Another is that a new Demark SELL Signal hit a few days ago. We’ve seen a handful of these come and go over the last few months. While most only led to short-term pauses, the SPX did eventually undercut the price level where each signal first hit. See chart below.

 

Despite these factors, the SPX’s two recently triggered bullish formations remain in play, with targets of 4,210 and 4,265. Holding above their respective breakout points trumps everything else.

 

 

 

5

 

As we’ve seen over the last eight weeks, breakout points actually have NOT held up well. Thus, despite the strong moves of late, we should be prepared for any scenario.

Both the XLE and Crude Oil are at important technical junctures – close to their 50 Day MAs and trying to avoid triggering bearish formations.

 

Copper is getting another shot at bouncing near its 50 Day MA, which has worked well over the last few months.

 

===================

Despite a risk-off start in futures markets, the Nasdaq 100 and DJI hit fresh highs despite the use of Johnson & Johnson (J&J) vaccine being halted in the US.

 

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SPX did really well last night, after scared by J&J news on future market. but there is one thing----volume is thinner !! be cautious

 

ASX200 future followed SPX , looks gonna have another crack on 7000 today.

 

 

 

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Thus far, April’s typically strong seasonality has not disappointed. Before this year, the SPX had been up 16 of the last 20 Aprils with an average move of +2.5%. Eight days into April, 2021, the SPX already is +4.25%.

 

 

 

2

 

More importantly, over the last two decades, Tech has witnessed a major inflection point vs. the overall market in April. As of yesterday’s close, the NASDAQ Composite is +5.66% in April, and the NDX +6.84%.

 

 

 

3

So far, the Tech rally has helped pull the NDX/SPX 14-Day RSI indicator from the VERY depressed 20 level back to 59, but the indicator remains in a one-year downtrend. That will need to change for this move to have staying power.

 

 

 

4

Both the US Dollar and Swiss Franc are at critical spots, near former breakout points and their respective 50 Day MAs.

 

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kinda think SPX gonna retest that 4105, before it can go any higher. imho. onlu guess work judge by it's last night's movement!

 

asx200 , might see buyer step in this morning to push it over 7000 again, bit od consolidation at 7000 round number atm. i'm bullish with asx200!! [ little biased]

 

 

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thought SPX gonna retrace last night, but it just keeps powering up even daily RSI in the over bought zone.

my day trading got stopped out.

 

long asx200 seems gonna pay off , target 7100 today as cooderman chart showed.

 

 

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seems asx200 went back to old dog days??? ---when US market up aussie go side way when US market down then aussie will down a lot more?? :weirdsmiley:

 

it's kinda strange to me that aussie market not out perform other major market during last three months!! :unsure:

i consider aussie market as conservative market. do i got it wrong??

 

 

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