Nate Geraci
January 15, 2009
Nearly all ETFs track an index (the exceptions are a small number of actively managed ETFs). Where they differ, however, is what indexes they track and how they go about their tracking. Understanding these differences is important to make sure you choose the right ETFs for your portfolio. This is especially true as the number of ETFs proliferate.
Before investing in an ETF, there are a number of characteristics about its underlying index you should investigate and understand. I’ve summarized the main ones below.
How are the components of the index selected?
Most indexes can be categorized as market indexes or custom indexes.
Market indexes are the most widely known kind and some of the largest ETFs track those indexes. A market index attempts to track the performance of a broad group of securities or sectors. These indexes include the S&P 500 , Dow Industrials, and Nasdaq Composite index. SPY is the largest ETF which tracks the S&P 500.
A custom index is simply any index constructed using specific rules to create a group of securities that doesn’t follow more widely known passive indexes. Many of them screen out certain companies based on qualitative or quantitative features using proprietary methodologies. ETFs that track socially responsible or clean energy, for example, are based on indexes developed by companies using their own qualitative criteria of what those themes represent. Similarly, quantitative indexes are ones using proprietary formulas to identify attractive companies in certain sectors of the market. Powershares is by far the biggest player in ETFs that track quantitatively determined indexes.
How are components of the index weighted?
Are they market-cap weighted, equal weighted, or fundamentally weighted? Once the components of an index are determined, the relative proportion of each component of an index must be determined. Most of the large, passive indexes (think S&P, Wilshire, Russell and MSCI indexes) are market-cap weighted, which means the relative weight of a company in the index is based on the total value of its shares. iShares, StateStreet, and Vanguard ETFs tend to be market-cap weighted indexes. Some indexes are equal-weighted, meaning the size of each company doesn’t matter – each company has the same relative weight. Rydex is probably best known as a sponsor of ETFs using equal weighting methodologies. Finally, some indexes base the relative weights of a company in an index on fundamental factors, such as relative earnings or dividends. WisdomTree is best known for its fundamentally calculated indexes.
How often is the index rebalanced and reconstituted?
When an index is rebalanced, the holdings of the index are bought or sold until they reach their intended weightings. The more often an index is rebalanced, the chance of receiving a capital gain distribution is increased. Also, the fund costs are likely to be higher. The most widely followed indexes are generally rebalanced either annually or semiannually. Many of the quantitative ones, however, are rebalanced quarterly and a few even are rebalanced monthly. When an index is reconstituted, the holdings of the index are actually changed. For example, when a company is added to the S&P 500 index, an ETF tracking that index must purchase the new company and sell the company being removed from the index. Similar to rebalancing, an index that is frequently reconstituted might increase the chance of capital gains in the ETF.
Once again, this isn’t an exhaustive list of items to consider. There are other questions to ask (e.g., is the index intended to outperform a benchmark or match it? what company developed the index?), but understanding these three main aspects of ETF indexes should give you a framework for determining whether an ETF belongs in your portfolio.
