Most ETFs replicate some form of indexing to reflect the performance of an underlying index, but ETFs do not necessarily hold every single security included in the index they intend to follow. For instance, "index optimization" or "enhanced indexing" techniques utilize a sampling of securities taken out of the underlying index as a way to estimate the performance of the overall index. This technique mostly serves as a way to reduce expenses since an ETF would incur higher costs by trading in more securities. Bond ETFs, for example, are based on underlying indexes that hold hundreds or even thousands of securities.

ETF sponsors often team up with large index providers to tap their brand, experience and scale. Some ETF managers construct their own benchmarks, however.

In the beginning, the ETF industry inked licensing agreements with the major index providers, such as Dow Jones, FTSE, MSCI, S&P and Russell, but as more fund providers entered the market, new providers started to build their offerings around lesser-known index providers or carved out sub-indexes from larger existing indexes. Others, such as WisdomTree, began tracking their own in-house indexes.

Market-Capitalization-Weighted Indexes
The first stock ETFs tracked indexes that weight stocks by their market capitalization, or the share price multiplied by the shares outstanding. Therefore, the market segment's biggest stocks can dominate the index and make them "top heavy."
The S&P 500 index is one example of a market-cap-weighted index, which is tracked by the popular SPDR S&P 500 ETF (NYSE Arca: SPY) and the iShares S&P 500 Index Fund (NYSE Arca: IVW). Other examples include the Russell 1000 Index, which is tracked by the iShares Russell 1000 (NYSE Arca: IWB); the Russell 3000 Index, which the fund iShares Russell 3000 (NYSE Arca: IWV) tries to reflect; and the Wilshire 5000 Total Market Index, which Guggenheim Wilshire 5000 Total Market ETF (NYSE Arca: WFVK) tries to follow.

Historically, market-cap-weighted indexes perform better when large-cap companies outshine mid-caps or small caps. Momentum-driven market environments may also help large caps outperform.

However, the market-cap-weighting methodology may be vulnerable to volatile market conditions that could cause fluctuations in the stocks of large companies. For example, the tech bubble helped technology company stocks rapidly appreciate in value, and market-cap-weighted indexes like the S&P 500 increased their exposure to the tech sector. The subsequent tech bubble burst had a large negative effect on indexes that increased weightings in tech stocks before the crash. The bigger they get, the harder they fall, it sometimes seems.

Price-Weighted Indexes
The Dow Jones Industrial Average is the most well-known price-weighted index. The SPDR Dow Jones Industrial Average ETF (NYSE Arca: DIA) tries to reflect the performance of the Dow.

Under a price-weighted index, each constituent stock is included as a fraction of the overall index, proportional to the stock's trading price. The price-weighted index is calculated by adding the sum of the prices on each stock and dividing that by the total number of stocks. As a result, stocks with a higher price will naturally have a higher weighting, which means that these stocks would have a greater effect on the overall performance of the index. Some market professionals consider this approach arbitrary and favor the S&P 500, which contains many more stocks.

Since component stocks are constantly changing, a price-weighted index will have to rebalance its holdings on a regular basis. For example, when a stock splits, the index divisor would be adjusted so the overall average is kept the same, because the split stock would have a lower price and a lesser influence on the index.

Equal-Weighted Indexes
In an equal-weighted index, each component stock is balanced so that even the smallest company and the largest company have an equal say in the index. An equal dollar amount is included for each stock in the index, making each stock component an equal percentage, or weighting, in the index. The benchmark is rebalanced periodically, sometimes quarterly, to bring the weightings back into alignment.

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