In the previous article, we discussed the types of ETFs. In this article, we will discuss how much exposure ETFs provide.
Exchange-traded funds are a lot like millennials: Born in the early 1990s, it didn’t become relevant until after the recession of 2007 – 09, but it’s been a force to be reckoned with ever since.
ETFs in the United States had $530 billion in assets in 2008. Today, that figure is estimated to be around $4.37 trillion.
Most investors today choose ETFs to tap into the underlying advantage of diversification that comes with it. Some investors also choose ETFs to access certain asset classes or investment patterns.
For instance, investors who want to preserve their capital will try to invest in bond ETFs and investors who want exposure to blockchain will invest in blockchain-exposed ETFs.
As a result, investors must understand what an ETF owns and how it came to own the securities in its portfolio. There are 63 different broad-based US large-cap ETFs to choose from.
Investors may feel they are all the same because they all draw from the same universe of 300 or 500 if you consider the S&P 500 a large-cap index of US-listed stocks, but this is a risky assumption.
ETFs can have various strategies of exposure to specific underlying indices.
Equally weighted ETFs
Equal-weighted indexes are precisely what they sound like. Regardless of how big or small a firm is, every stock in the index has the same weight.
As a result, even Apple will have the same weight as the tiniest business in the S&P 500. The Invesco S&P 500 Equal Weight ETF (RSP) is the most widely traded equal-weight ETF.
Let’s take an example and construct an equal-weighted ETF
| Stock | Return (in %) | Equal weight | Contribution Equal Weight (return*equal weight) |
| A | 4 | 10 | 0.4 |
| B | 3 | 10 | 0.3 |
| C | 7 | 10 | 0.7 |
| D | 4 | 10 | 0.4 |
| E | 12 | 10 | 1.2 |
| F | 3 | 10 | 0.3 |
| G | 1 | 10 | 0.1 |
| H | 15 | 10 | 1.5 |
| I | -5 | 10 | -0.5 |
| J | 2 | 10 | 0.2 |
| TOTAL | 100 | 15.4% |
Thus, the return of our hypothetical ETF is 15.4%
Market weighted ETFs
Like many other stock indices, the S&P 500 is a market capitalization-weighted index. By multiplying the share price by the total number of outstanding shares, the market capitalization of each stock is determined.
The index’s weightings will be dependent on the companies with the most significant market capitalizations or values.
While the S&P 500 index comprises several companies, the MWI (market value-weighted index) sector weight is calculated by adding the individual weights of the companies that will make up that sector.
Let’s take an example and construct a market-weighted ETF
| Stock | Return (in %) | Market weight | Contribution Equal Weight (return*equal weight) |
| A | 4 | 10 | 0.4 |
| B | 3 | 20 | 0.6 |
| C | 7 | 5 | 0.35 |
| D | 4 | 15 | 0.75 |
| E | 12 | 5 | 0.6 |
| F | 3 | 5 | 0.15 |
| G | 1 | 10 | 0.1 |
| H | 15 | 10 | 1.5 |
| I | -5 | 10 | -0.5 |
| J | 2 | 10 | 0.2 |
| TOTAL | 100 | 4.15% |
Thus, the market-weighted ETF return is 4.15%.
Volatility weighted ETF
Volatility weighting, in particular, does not use low volatility as a selection criterion.
It’s a weighting strategy that helps an index diversify by addressing the concentration in cap-weighted indices when a few stocks dominate the index’s performance and risk profile.
The objective is to use a company’s stock price volatility over the last few trading days to inversely weigh shares. Based on that metric, the least volatile equities are weighted more while the most volatile stocks remain in the portfolio with a lesser weight.
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Fundamentally weighted ETF
The components of a fundamentally weighted ETF get their rankings according to their fundamentals rather than their market capitalization.
As a result, the ETF only invests in equities that have the prediction to show increased growth.
This ensures that the organizations with the best results in their core business operations receive the most weight, rather than those whose market value has increased.
A constant upward trend in the top line is one of the essential components of a company’s long-term growth.
Thus, being cautious about exposure and not going by the name blindly will help select ETFs for the portfolio.
FAQs
What is the risk exposure of ETF?
Most investors today choose ETFs to tap into the underlying advantage of diversification that comes with it. Some investors also choose ETFs to access certain asset classes or investment patterns.
For instance, investors who want to preserve their capital will try to invest in bond ETFs, and investors who want exposure to blockchain will invest in blockchain-exposed ETFs.
As a result, investors must understand what an ETF owns and how it came to own the securities in its portfolio.
Is ETF safer than stocks?
Since ETFs are diversified, which means they hold a basket of stocks or other securities, they carry less risk compared to stocks. But ETFs can be bought and traded like stocks.
Do ETFs try to beat the market?
Most ETFs and index funds try to replicate an index of stocks or other assets. They try to imitate the index and try to match its returns.
Does ETF really work?
ETFs are generally considered low-risk investments. They are low-cost and offer diversification because they hold a basket of stocks or other securities.
