How Different Weighted Indexes Play Into ETFs
Many Exchange Traded Funds (ETFs) use indexes as their underlying benchmarks, so it is equally important to understand the different types of indexes. Your ETF investing strategy depends on them. The three main types of indexes are price-weighted, value-weighted, and pure unweighted.
With a price-weighted index, the index trading price is based on the trading prices of the individual securities (stocks) that comprise the index basket (known as components).
In other words, the stocks with the higher prices will have more impact on the movement of the index than stocks with lower prices, since their price is "weighted" higher.
If a stock goes from $100 to $110, because its price is higher, it will move the price-weighted index more than a stock that goes from $20 to $30, even though the percentage move is greater for the lower-priced stock.
One of the most popular price-weighted indexes is the Dow Jones Industrial Average (DJIA), which consists of 30 different components. In this index, the higher-priced stocks move the index more than those with lower trading prices, ergo price-weighted.
In the case of a value-weighted index, the amount of outstanding shares comes into play. To determine the weight of each stock in a value-weighted index, the basic formula (without getting too complex for demonstrative purposes) is to multiply the price of the stock by the number of outstanding shares.
If Stock ABC has 6 million outstanding shares and trades at $15, then its weight in the value-weighted index is $90 million (15 x 6). But if stock XYZ is trading at $30, and has only 1 million outstanding shares, its weight is $30 million (30 x 1).
So, in a value-weighted index, ABC would have more impact in the movement of the index, but in a price-weighted one, it would have less value since its price is lower. Some examples of value-weighted indexes, sometimes called capitalization-weighted indexes, are the popular MSCI family of strategy indexes as well as the widely tracked S&P 500 index.
The third variation of weighted indexes is the unweighted index, which some call the equal-weighted. All stocks, regardless of share volumes or price, have an equal impact on the index price. The price change in the index is based on the percentage return of each component.
Say there are three stocks in our unweighted index example: ABC, XYX, and MNO. Regardless of how many shares you have of each stock or the actual trading price, look at the percentage of price movement. So if ABC is up 50% and XYZ is up 10% and MNO is up 15%, the index is up 25% = (50+10+15) / 3 (the number of stocks in the index).
This calculation is based on an arithmetic average, but some unweighted indexes will use a geometric average calculation as well. So then the formula would change to (1.5 + 1.1 + 1.15) [1/3]. Typically, the geometric formula will generate a slightly lower percentage than the arithmetic formula, but still should be relatively close.
While there are other types of weighted indexes—revenue-weighted indexes, fundamentally-weighted indexes, factor- and even float-adjusted indexes—the three outlined here are the ones most typically used with ETFs.
Unlike funds that are chosen by a manager, most ETFs are passive with stocks selected automatically to match a particular aspect of the market. Based on the type of fund, different proportions of the underlying stocks are held. Because ETFs are automated, they typically carry lower operating costs.
There are many arguments about which types of weighted indexes are best, but in the end, it depends on your personal situation.
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