While much of the financial world is in a state of uncertainty that has left investors apprehensive, market darlings such as Apple have headed for the stratosphere.
In the world of indexing, the meteoric rise of Apple, Google and other technology companies has created a divergence between market-cap-weighted ETFs and their fundamentally weighted counterparts.
The divergence is growing too: Valuation multiples for select tech companies have expanded skyward and continue to comprise an ever-greater portion of market-capitalization-weighted ETFs and indexes.
Market-cap-weighted indexes, such as the S&P 500, and the ETFs that track them, increase the size of their holdings as the security itself becomes more expensive. So, as the share price of Apple Inc. (Nasdaq: AAPL) increases, ETFs that track market-cap-weighted indexes buy more of it.
To some, this implies that the ETF is definitively "behind the curve," and begs the question, Is paying for popularity a sound investment tactic?
In contrast, fundamentally weighted funds use factors such as sales, cash flow, dividends and book value to determine relative weighting size.
To drive home the point, fundamentally weighted ETFs have actually reduced exposure to many of this year’s hottest tech companies at the same time as market-cap-weighted funds are boosting exposure and droves of investors are busy talking themselves into jumping into Apple before it’s too late.
Two popular funds that offer exposure to the same space make the point perfectly. They are:
- PowerShares’ FTSE RAFI US 1000 Portfolio (NYSEArca: PRF), a fundamentally weighted fund with an index designed by Rob Arnott’s Research Affiliates that has assets of $1.45 billion
- State Street’s SPDR S&P 500 ETF (NYSEArca: SPY), the first U.S.-listed exchange-traded fund and the biggest in the world, with assets of more than $118 billion
The first chart compares the two funds’ holdings at the start of this year and the latter chart compares them at the end of the third quarter of 2012.
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