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ETF: Weighting and single stock risk

Index weighting can have a significant impact on the performance of your investment.

In the local market, Naspers is dominating indices. Those weighted by market capitalisation are especially affected, with the industrial giant taking up 20%. That means for every R100 you invest in a vanilla top 40 ETF, R20 will buy Naspers. Those who hold ETFs weighted by market capitalisation have profited from the company’s performance. When Naspers is doing well, your money works hard.

However, it’s important not to lose sight of your remaining R80. Money invested in Naspers can’t be invested in any of the other companies on the index. When Naspers outperforms the other companies, this doesn’t matter. However, when other companies outperform Naspers, the large investment in Naspers presents an opportunity cost. 

In the past 12 months, Naspers delivered lower returns than the four companies below it on the S&P SA 50 Index, according to Zack Bezuidenhoudt of S&P Dow Jones Indices. While the company’s return of 22.2% between August 2016 and August 2017 is not to be scoffed at, other index constituents have outperformed it significantly.

 

 

The CoreShares Top 50 (CTOP50), which tracks the S&P SA 50 Index, determines weighting by market capitalisation, but each company’s exposure is limited to 10%. If you were invested in a capped index like this one, only R10 of your R100 would have gone to Naspers, leaving a larger chunk to be distributed among the remaining constituents.

In an index weighted by market capitalisation, only 3.63% of your investment would have gone into the highest performer – in this case BHP Billiton. In the capped index, nearly 10% of your investment would have benefited from BHP’s performance. In an equal-weighted index, you would have as much exposure to Naspers than BHP. In this case, an index weighted by market capitalisation with a 10% on single company exposure would have delivered a greater return on the top five constituents than any other index.

While ETFs eliminate a lot of investment complexity, index weighting can have a significant impact on the performance of your investment. Each type of weighting can offer benefits in particular market conditions. Understanding the implications of index weightings is critical in making index investment decisions. 

Kristia van Heerden is CEO of Just One Lap.

This article was first published on Just One Lap. To access the original, please click here.

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“Each type of weighting can offer benefits in particular market conditions.”
sure – in hindsight…

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