Imagine owning a portfolio of 10 stocks, where your
position in one is eight times as big as another, and where
three of your holdings contain 40% of your overall
portfolio's value. That seems kind of problematic, doesn't
it? Doesn't it seem like it might be smart to redistribute
that money, perhaps roughly evenly between the 10
holdings?
Well, that imaginary portfolio is kind of like many of the
indexes we know and love.
We've long pointed out how some major stock market indexes
leave a lot to be desired. The Dow Jones Industrial
Average ("the Dow"), for example, contains just 30 companies,
and it's price-weighted. It's harder to get dumber than that,
if you ask me. It means that
IBM (NYSE: IBM), recently trading around $122
per share, is well more than seven times more influential in
the index than
General Electric (NYSE: GE), with its price
around $16 per share. Both might increase by 5% on a given
day, but that would mean an $0.80 jump for General Electric,
compared to a $6.10 rise for IBM. IBM's $6.10 would create a
much bigger Dow move, even though they're both 5% moves. See?
Silly.
Johnson & Johnson 's (NYSE: JNJ)
market
capitalizationwas recently around $169 billion, compared
to $121 billion for
Pfizer (NYSE: PFE). So J&J is roughly 40%
bigger measured by market cap. But since Johnson &
Johnson's price is around $60 and Pfizer's around $18,
J&J has more than three times the influence of Pfizer in
the Dow.
A reasonable alternative to price-weighting an index is to
weight companies by market cap. That way, the bigger the
company, the greater its importance and influence in an
index. That's how the S&P 500 handles things. But that
has some drawbacks, too. After all, it means that the biggest
companies, such as
ExxonMobil (NYSE: XOM) and
Microsoft , really dominate all others.
Microsoft makes up about 2% of the index, while
Hasbro (NYSE: HAS), also respected, makes up
0.04%. If you prefer Hasbro to Microsoft -- as our
Motley Fool CAPS communitydoes, giving Hasbro five stars
to Microsoft's three -- then cap-weighted indexes won't get
the job done either.
The top 10 holdings in the S&P 500 make up nearly 20%
of the index's value, and the first 50 companies make up more
than half of it! That leaves less than half for the remaining
450 companies.
Creative alternatives
Fortunately, we're not stuck with these kinds of
allocations, where your money isn't necessarily focused on
the companies with the most potential or the strongest
performances. The innovative investing arena of
exchange-traded funds, or ETFs, has introduced some
interesting alternatives.
Some ETFs, such as the
SPDR S&P Biotech (XBI) and the
SPDR S&P Semiconductor (XSD), feature
equal weighting, where each component of the index is
weighted equally, at least when the index is constructed. So
if you look at the biotech ETF now, you'll find that
Amgen (Nasdaq: AMGN) and
OSI Pharmaceuticals each weigh in at about 4%
of the ETF's assets, though Amgen's market cap is around $62
billion, and OSI Pharmaceuticals' is closer to $2
billion.
Fundamentally speaking ...
Then there's "fundamental weighting," where holdings in
an ETF are weighted according to various fundamental
criteria, such as their earnings, revenue, or dividends. Continued... |