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.
- 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 formulae 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.
If you want to invest in global companies expected to benefit from the transition to a more sustainable planet and gain the intellectual amd market knowledge of an ETF, have a look at the new BetaShares Climate Change Innovation ETF (ASX: ERTH).
The ETF aims to track the performance of an Index which includes up to 100 of the largest global companies that derive at least 50% of their business from activities that enable the reduction or avoidance of CO2 emissions, and excludes companies with direct involvement in the fossil fuel industry and certain other negative business activities.
Companies in ERTH’s portfolio fall into the following sectors:
- renewable and clean energy
- green transportation
- water and waste improvements
- decarbonisation-enabling solutions
- sustainable products.
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