The most common difference arises in the index’s construction process. Different index providers may have different definitions for classification of Growth stocks, Value stocks, Small-cap, Large-cap, etc. when designing and building an index.
The index providers may also have differing approaches to sector weighting methodology that can dramatically alter the index’s composition.
Example: If two providers each build a new index that is to hold shares in companies A, B, C, and D, the constituents are the same, but if each weights their respective index toward different companies, the indices will each generate a different outcome. So if the constituents are the same, but one provider allocates 10% to company A and the second provider allocated 25% to company A, it is easy to see how each index’s weighting will lead to different index outcomes.
There are two typical weighting methodologies – Capitalization-weighted and Equal-weighted. In a Capitalization-weighted index structure, each constituent’s weight in the index is based on its total market capitalization. In an Equal-weighted index, all individual stocks in the index, are weighted equally regardless of their market capitalization.
Note: Investors need to be aware of these differences in index construction to better understand the different risk and return profiles between the various ETFs and their underlying indices. With index providers creating indices for the same asset category using differing methodologies, understanding these differences is key to selecting the right ETFs when designing an investment portfolio.