Have you ever wondered how Standard & Poor’s selects the companies whose stocks go into the S&P 500 index?  They utilize a methodology called capitalization weighting (cap weighting for short), in which inclusion is based on a company’s market capitalization.  That’s a fancy term for how much investors value the company, and it is calculated simply by multiplying the current price of one share of stock by the total number of shares held by all investors in the market.  If a company’s market capitalization puts it in the top 500 of all U.S.-based public companies, it is not only included in the S&P 500 index but weighted based on its market capitalization relative to the total market capitalization of all companies in the index.

It turns out there are other ways one can structure the very same index.  There’s the simplistic equal weighted approach, in which every company in the index is given the same percentage weighting (0.2% in the case of the S&P 500).  You can find a number of ETFs that utilize this methodology.  Proponents of this approach argue that the problem with cap weighting is that it inappropriately concentrates the index in a few “hot” companies, and that the performance of a single company (recall Apple in 2011) can disproportionately impact the entire index.  Critics argue that equal weighting results in an index that is overrepresented by smaller companies, resulting in higher volatility.

Probably the indexing model that has garnered the most interest over the last decade or so is fundamental indexing, most actively promoted by Rob Arnott of bond investment company PIMCO.  Instead of using market valuation as the weighting factor, fundamental indexing uses accounting or so-called fundamental measures to weight each stock in the index.  These include measures such as company sales, earnings, book value, cash flow, or dividends, to name a few.  Fundamental indexing proponents claim that these measures are more appropriate for valuing (and consequently weighting) the stocks in the index than the market capitalization measure, which favors stocks with rising prices.  The implication is that growth stocks with poor current fundamentals but high price momentum tend to be overpriced.  However, I can find no empirical or theoretical evidence to support such a viewpoint.

Over the last decade, both equal weighted and fundamental weighted S&P 500 index funds have in fact outperformed funds based on the traditional cap weighted index.  But not consistently.  During market downturns, the equal weighted indices not surprisingly have shown greater volatility.  But so too have the fundamentally weighted indices.  While you might intuitively expect that the stock prices of companies with stronger fundamentals should do better during rough periods, the facts do not bear this out.

In the end, it appears that the market is pricing stocks appropriately.  The more risk you are willing to take, the greater the potential return, and vice versa.  And if you prefer utilizing index funds or ETFs, even in large cap stocks, that most popular segment of the U.S. stock market, you still have the ability to dial up or dial down the risk based on your choice of index approach.