ETF: How ETF weighting is like a fruit salad

Kristia van HeerdenETF Blog, Latest

ETF weightingETFs are like a fruit salad.

When you buy a fruit salad, you get nice variety of complementary fruit for one price in one transaction. It’s great, because you can eat all of your favourite fruit without having to buy a packet of each. Sometimes fruit salads are seasonal. Sometimes they are themed, like a tropical fruit salad. Whatever the salad, you always know what’s in it before you buy it, because you can see all the fruit.

When you buy an ETF, you get a nice variety of shares for one price in one transaction. It’s great, because you can own all of your favourite companies without having to buy shares in each. Sometimes an ETF buys the whole market. Sometimes they’re themed, like an ETF that invests only in financial companies. Whatever the ETF, you always know what’s in it before you buy it because you can see all of the shares in the ETF.

The problem with both fruit salads and ETFs is that it can be hard to choose which one you want. We’ll leave your fruit salad selection technique up to you, but we can guide you in the ETF department. As we’ve discussed elsewhere, once you’ve taken care of asset classes and sectors*, you can differentiate between ETFs based on their weighting.

In its simplest form, an ETF buys the market – this is called weighting by market capitalisation or market cap-weighted ETFs. If a company has a lot of shares and a high share price, it represents a larger part of the market and therefore the ETF. This is nice and simple. If it were a fruit salad, it would have more local, seasonal fruit which are abundant and fewer exotic, imported fruit.

Those who don’t like this type of investment might choose an equally-weighted ETF. Each company gets an equal amount of representation in the ETF. This type of ETF is nice and robust. It doesn’t shoot the lights out when a single company performs well, but it also doesn’t do as poorly when a single company fails. If it were a fruit salad, there would be an equal amount of each type of fruit, for those who don’t like too much of a good thing.

Some ETFs let you buy more of a big company, but up to a point. For example, a single company can only make up 10% of the ETF. In a fruit salad, you’ll have more seasonal, local fruit, but not so much that it completely overpowers the more exotic fruit.

Earlier this year, however, Absa upset the apple cart. They introduced a completely new type of weighting, called equal risk contribution (ERC). Instead of looking at the size of the company, the ETF weights companies by how much risk they add to the index. The idea is to ensure that each company contributes the exact same amount of risk.

Some companies’ share prices move more than others. This could have to do with the type of business, industry or geography within which the company operates. These companies contribute more to the up and down movement of an index, or the volatility,  than companies whose share prices don’t move a lot.

In an equal risk contribution ETF, you don’t want one company contributing more to the share price movement of the ETF than another. For that reason, you give less weight in the index to companies whose share prices move a lot and more to companies with stable share prices. This ensures a more stable ETF.

Think of this like a completely new type of fruit salad for people who don’t want to eat too much sugar. The amount of sugar in the salad will be set at a healthy level. The fruit included in the salad will each contribute the same amount of sugar to ensure that you never get more than the predetermined dose of sugar.

How you choose between these ETFs depends on which strategy makes more sense in your portfolio. If you like to keep things simple, you’ll go for a market cap-weighted ETF. If you don’t like too much share price movement, you’ll opt for an equal-weighted or capped option. If you want to reduce the amount of movement in your ETF as much as possible, the ERC ETFs might be a better fit.

*You can also differentiate by factors – a topic we’ll get to in a future blog.

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