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.

Examples of an equal-weighted index include the Standard & Poor's 500 Equal-Weight Index, which the Rydex S&P Equal Weight ETF (NYSE Arca: RSP) tries to reflect, and the Wilshire 5000 Equal-Weight Index.

Because the various stock capitalizations are held equally within the indexes, mid- and small-cap companies have a greater impact on the overall performance of an equally weighted index than they do on a market-cap-weighted index.
Consequently, equally weighted indexes have historically done quite well when market environments favored small-cap firms. In addition, mid- and small-cap companies usually do better over the long term and equally weighted indexes will most likely reflect the better long-term performance. Still, the so-called small-cap premium often takes many years to assert itself.

To ensure that the index holds an equal weighting on each component, the index may have high turnovers since stocks that performed well may be trimmed and those that have not done well will be bought. ETFs based on an equal-weight methodology may charge higher fees since the ETF incurs trading costs each time the fund rebalances. Additionally, equal-weight ETFs may also experience more bumps along the road due to the fund's larger weighting in volatile small-cap stocks.

Fundamental-Weighted Indexes
Rob Arnott of Research Affiliates argues that fundamentally weighted index portfolios outperform the cap-weighted S&P 500 over the long term because market-cap-weighted indexes are inefficient, which would lead to underperformance and lost opportunities.

The FTSE RAFI US 1000 Index is an example of a "fundamental" index that weights the 1,000 components based on current quantitative data, which includes a rules-based model with fundamental factors on sales, cash flow, book value and dividends. Arnott believes that a cap-weighted index overweights stocks that are above their fair book value and underweights companies that trade below their true fair book value, which may result in reduced returns on the market-cap-weighted index.

Invesco PowerShares recently overhauled some of the existing ETFs in its Intellidex series and added them to the RAFI Fundamental U.S. Series based on the Research Affiliates Fundamental Index methodology. The "fundamental pure style ETFs" weight companies based on a stock's financial size in order to diminish price distortion and provide a greater objective representation of the market.

Tracking Error
Advisors focus on the benefits of ETFs-transparency, low fees, intraday liquidity and so on-but if the ETF falls short of its benchmark index, they lose their advantage over active mutual funds and those ETFs that do track their underlying benchmarks. Passive or indexed investing is often a game of inches.

ETF investors should monitor tracking error in ETFs, since any lag between the fund and the benchmark could translate to losses in returns. A tracking error may be caused by any number of factors, including stocks with less liquidity, fund fees, optimization strategies, changes in indexes, dividend reinvestment requirements and the legal requirements a fund must follow.

The recent proliferation of ETFs with niche investment strategies cover areas where trading is less liquid. For instance, international and global ETFs will more likely see a greater disparity between their prices and their net asset values because the ETFs try to provide exposure to markets that are difficult to access, which tends to lead to higher fees and a heavier emphasis on optimization strategies. In contrast, U.S. equities-based ETFs more closely reflect their underlying indexes as a result of lower expenses and the relative ease in which the funds may access the underlying assets.

The Benefits of Index ETFs
Because of the passively managed investment styles found in index ETFs, the costs tend to be lower. Fund managers would only monitor any changes in the weightings of the underlying index and rebalance ETF holdings accordingly.

It is well-documented that most active managers fall short of their benchmarks over longer periods, and 2011's range-bound, trendless market is proving difficult for many. By following an index, ETFs will consistently adhere to a set guideline and investment style.

While a passive, indexed-based strategy with ETFs may seem rather boring, history has shown that attempting to beat the market usually ends in failure.

Disclosure: Tom Lydon is a board member of Rydex|SGI.

Tom Lydon is editor and publisher of ETF Trends, a Web site with daily news and commentary about the fast-changing trends in the exchange-traded-fund (ETF) industry. Lydon is also president of Global Trends Investments, an investment advisory firm specializing in the creation of customized portfolios for high-net-worth individuals. Disclosure: At the time of publishing, Mr. Lydon's clients owned IndexIQ Agribusiness Small Cap ETF (NYSEArca: CROP).