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. Price weighting means that IBM (NYSE: IBM ) , recently trading around $122 per share, is 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 capitalization was 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 approach has 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 community does, 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.
Several of The WisdomTree family of ETFs weight components by fundamentals. For instance, in its LargeCap Dividend Fund (DLN), stocks with higher yields will be more heavily weighted. Thus, Pfizer, with its recent 3.6% yield, makes up considerably more of the fund's holdings than does IBM, with its 1.8% yield.
Personally, I think a dividend-weighted fund makes more sense than using some of the other metrics. For instance, the RevenueShares Large Cap (RWL) ETF is revenue-weighted, which doesn't strike me as the most promising approach. Before looking at its list of top components, I imagined that I'd see a lineup similar to that of the S&P 500.
I was partially correct; it also contained an automaker in the No. 2 spot, becauise it generated huge revenue despite having negative profit margins and negative revenue growth. If you're looking for strong growth, I'd think that the nation's companies with the highest sales numbers are not your best bets, since it's hard to boost sales when they're already greater than $100 billion or $200 billion.
Your Foolish marching orders
If you're investing in any index funds or ETFs based on indexes, pay attention to how the holdings are weighted, and make sure the system makes sense to you. If you believe in all of an index's holdings, then you might want to look for equal-weighting, where smaller companies aren't overshadowed by bigger ones. But if the stocks at the top of a fund's holdings are exactly the ones you want to own the most of, then you're probably in the right fund.
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