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The ETF Book: All You Need to Know About Exchange-Traded Funds, Updated Edition by Richard A. Ferri

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CHAPTER 9

Index Security Weighting

Security selection is the first half of index construction and weighting those securities is the second half. The weight allocated to each security is important because different weighting schemes applied to the same basket of securities can have a profound impact on the performance of the index.

Index providers allocate securities using three basic methods: capitalization weight, fundamental weight, and fixed weight. A capitalization-weighted index bases the allocation on the relative market value of each security in the index. Fundamental-weighted indexes use qualitative factors or financial information other than capitalization to allocate among index constituencies. Fixed weighting assigns a set weight to each security in an index or a set weight to industries. Leverage, short (inverse), and long-short exchange-traded funds (ETFs) are also considered fixed weight indexes because the market beta is changed by a fixed amount.

The three columns in Index Strategy Boxes represent these three weighting methods. Most indexes fit easily into one of the three categories, although some indexes use a combination of weighting method. In those instances, the weighting strategy that affects performance the most is selected.

Table 9.1 provides the three broad security weighting categories and examples of methods under each category. See Appendix A for a larger list of weighting methods under each category. Appendix A is an abbreviation guide for Index Strategy ...

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