Many investors don’t understand exactly what they are buying when they look at Index ETF’s or funds. Investors should know the differences in “weighting” of stocks in an index or ETF. Weighting is the method that an index or ETF uses to determine what % of the index goes to buy each stock. Investors may think they are buying a highly diversified fund or ETF and not realize how “top heavy” they are in a few larger or higher priced stocks. Buying an Equal Weight ETF might provide an investor with more diversification.
Furthermore, many investors may be looking for diversification across multi-sectors yet don’t know for example that a NASDAQ index, like QQQ has no financial stocks. Or if you buy both the SPY and QQQ ETF’s you’ll end up with a big investment in Apple (APPL).
QQQ – Non-financial stocks 57% technology, 21% Consumer Cyclicals (78% total)
SPY – Well balanced Technology 21%, Financials 15%, Healthcare 14%, Consumer Discretionary 12% Industrials 10% (72% total)
Dow Jones: Price-weighted (DIA)
NASDAQ: Market capitalization-weighted (QQQ)
S&P 500: Market capitalization-weighted (SPY)
Russell 2000: Market capitalization-weighted (IWM)
Guggenheim S&P 500: Equal-weight (RSP)
A price-weighted index (Dow) uses the price per share for each stock included and divides the sum by a common divisor, usually the total number of stocks in the index. Example, Goldman Sachs is a high price stock about $240/share, Cisco, a much larger company has a $31 share price. If you buy $1,000 of DIA, you get $80 worth of Goldman and only $1 worth of Cisco.
The market capitalization weighting is a stock market index weighted by the market capitalization of each stock in the index. A larger company account for a greater portion of the index. Most indexes are constructed in this manner, like the S&P 500, NASDAQ 100 and Russell.
Apple for example, makes up 11% of the NASDAQ top 100 (QQQ), and 3.5% of the S&P 500 (SPY). In the case of QQQ, the top 5 stocks make up over 1/3 of the value of the 100 total stocks, very top heavy.
Here is a list of the top 5 holdings in the NASDAQ 100
Investment Option – Equal Weighted Index
Guggenheim S&P 500, Equal-weight (RSP), this ETF is an equal weighted index. Each stock gets the same weight. Over a period of time the RSP has provided a better return than the SPY. In addition the RSP provides a larger exposure to small-mid cap equites and more diversification.