The key reason why we opt for the market cap-weighted approach is to be more representative of industry dynamics. We view many themes as sector disruptors, or new industries that are challenging existing paradigms. In such emerging industries there is still much to be settled. Which company will be the dominate robotics maker in 20 years? Which company will struggle and go bankrupt? With a market cap-weighted approach, we gain more exposure to the companies as they begin to dominate an industry and reduce exposure to those that are failing. By contrast, an equal-weighted approach is forced to sell exposure to companies as they grow and buy those that struggle. In other words, market-cap weighting increases exposure to Amazon as it grows and reduces exposure to Pets.com as it dies. An equal-weight strategy would sell Amazon while it grows and buy more of Pets.com as it fails.
Some might argue that in the aggregate smaller companies offer higher growth opportunities than larger companies and therefore warrant more exposure than a market cap-weighting scheme offers. But we do not always find this to be the case in disruptive industries. Using history as our guide, recent powerful themes have demonstrated that larger companies enjoy enormous benefits due to economies of scale and network effects. Apple and Samsung dominate the smart phone market due to the high fixed costs of developing cutting-edge phones and software. Google dominates search as more searches breed better search results, which in turn breeds more people searching. In e-commerce, Amazon dominates because of both the network effects of having a two-sided marketplace connecting buyers and sellers, and the economies of scale of efficient distribution.
Going forward, we think this trend will continue. In FinTech, for example, we believe mobile payment providers will have strong economies of scale through access to data and complimentary business services offerings. In the robotics industry, the high fixed costs of developing both an advanced robot and the software required to operate it will continue to accrue benefits to the market leaders. In short, we want to own more of the bigger companies. Yes, small companies will emerge and challenge the status quo, but in many of these new industries we think there are substantial economic benefits to being larger. And as a small company begins to prove itself, we’ll begin to own more of that company.
The advantages of better representing the dynamics of an emerging industry, combined with the added benefits of improved liquidity and lower turnover which help reduce transaction costs, ultimately sway our decision to favor market cap-weighting schemes. While market weighting is not perfect, many of the indexes we track include minor variations to a pure market cap-weighting approach to address some of its shortcomings. For example, many indexes we track include a cap on the largest position size to mitigate overly top-heavy portfolios. The index tracked by our Robotics & AI ETF, for example, caps the largest position size at 8%. We believe this approach gives us an optimal solution for thematic investing: an index that is representative of the industry, mitigates excessive levels of concentration, maintains high liquidity and has lower turnover.
Conclusion
There’s no single "right" way to weight an ETF because there are tradeoffs with each approach. In the thematic growth space, we favor market-cap weighting as a way of mirroring an emerging industry, improving liquidity and reducing turnover. In investment strategies where minimizing idiosyncratic risks is more of a priority, we believe equal weighting can still make sense. This is the case with our SuperDividend suite, for example, where mitigating the impact of a company changing its dividend policy is preferred. But as investors consider different ETFs, it’s important to remember not to just look at what an ETF holds, because how much can be just as significant in aligning one’s investments with their goals.
Jay Jacobs is head of research and strategy at Global X.