All these indices use a modified market capitalisation-weighting methodology as the basis for their construction. In other words, stocks are weighted according to their market value, but subject to certain adjustments. The typical modifications to "pure" capitalisation-weighting are a cap on single stock weightings, and a minimum free float percentage. These can vary quite considerably.

Does this matter for investors? Yes, as the rules can lead to some indices being much more diversified than others. This can have quite dramatic real-life consequences for their performance, as recent months have reminded us.

From the point of view of the number of constituents, the FTSE 100 has the broadest spread, with 100 stocks, although, significantly, there is no cap on any individual company's weighting. The effects that a bubble can have on index weightings was shown in 2000, when telecoms company Vodafone hit a 13% index share, massively outweighing the other 99 companies in the benchmark.

FTSE responded to demand from some investors for less concentrated versions of its equity indices by bringing in capped versions of the FTSE 100 and FTSE All Share in 2005, although these have yet to gain traction amongst investors.

Looking at the number of constituents and the maximum single stock weightings in conjunction, in theory the DAX and the BEL 20 are the most diversified, since they combine a relatively small number of constituents with a relatively low maximum individual stock weighting.

However, the events of last October, when a record-breaking short squeeze in Volkswagen shares sent the company's weighting in the DAX to around 30%, and caused an emergency revision of the index (we covered this story on www.indexuniverse.eu/ at the time) show that it is important to check the minimum free float percentage as well.

The DAX index rules had traditionally allowed the inclusion of stocks with a relatively small free float of 5%, but this was raised to 10% in November last year, a month after the Volkswagen squeeze occurred. Even so, the DAX permits a smaller minimum free float for its index constituents than the other European indices in the table, perhaps reflecting the predominance of family and other non-traded share holdings on German companies' registers.

Another unusual feature of the DAX is that it is calculated on a total return basis (including the reinvestment of dividends). With the exception of Norway's OBX index, which follows a similar methodology, all the other equity indices in the table are price indices only. This, incidentally, means that ETFs tracking the DAX have to be domiciled in Germany (if the ETFs are using a physical replication methodology) in order to avoid withholding taxes, which would otherwise prevent them from tracking the index.

Moving to the other end of the diversification scale, the main Swiss equity benchmark, the SMI, has a very significant concentration in its largest stocks. According to the latest index factsheet from the Swiss exchange's website, three companies - Novartis, Roche and Nestle - jointly represent over 60% of the SMI. The Norwegian OBX index also has a heavy bias towards a few large stocks, with energy giant Statoil's weighting exceeding 30%.

Summary

Despite the recent rise in popularity of ETFs tracking equity sectors, country funds are still the mainstay of many investors' portfolios, whether retail or institutional. According to the ETF market participants we surveyed, this situation looks as though it will continue. But there's a surprising variety of index construction methods across Europe, which can lead to some benchmarks being more diversified than others. So, if you're going to build an equity portfolio using country ETFs, it's worthwhile knowing about free floats and maximum stock weightings!

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