The ABCs Of ETFs

June 12, 2008

 

The ABCs Of ETFsExchange-traded funds are benchmarked to an expanding universe of indexes. Those indexes range from traditional passive benchmarks that use capitalization weighting to sophisticated quantitative strategies and alternative weighting methods. This article links index strategies to ETFs expenses. There is clear evidence that ETFs following more sophisticated index strategies charge higher fees than ETFs following passive market benchmarks. I use a new database at ETFguide.com to classify ETFs by index strategy and create a unique pricing model for ETFs based on index strategy. The model enables investors to compare the expenses of ETFs with like strategies, and guide ETF providers toward a sound pricing model.

Index Classification Terminology

Indexes can be classified by basic purpose and specific strategy. There are two basic types of indexes. A market index is a traditional “plain vanilla” measure of market value that uses passive security selection and weights securities based on market capitalization. To the contrary, a strategy index is a technique for investing in the markets rather than a measurement of market value. In a sense, market indexes track market “Beta,” and strategy indexes attempt to create some type of “Alpha,” either in financial terms or in expressive terms such as with socially responsible indexes.

Market indexes are designed to measure the performance of financial markets. They are characterized by passive security selection and capitalization weighting. Security selection can include the entire universe of securities, a sampling of securities or one item such as the price of gold. Capitalization weighting can be in the form of full float, free float, liquidity or production weighting. The primary purpose of market indexes is tied to measurement, not performance. They provide a measurement of market risk and return, which can be summed up as beta.

Strategy indexes are investment strategies. They are custom-made to seek “Alpha” in the marketplace in whichever way their creators define alpha. ETF companies that use strategy indexes often imply that their products offer something better than ETFs that follow market indexes. WisdomTree promotes their fundamental strategy indexes as “Built differently, with the goal of higher returns with less risk.” PowerShares claims their ETFs offer “exceptional asset management tools” through the replication of “enhanced indexes.”

Index strategy classification goes to a different level with the use of the Index Strategy Box categorization system. ETFs are separated into different categories based on their security selection and security weighting techniques. There are three broad selection strategies: Passive, Screened and Quantitative; and three broad weighting strategies: Capitalization, Fundamental and Fixed. The three security selection methods and three security weighting strategies form a matrix. Figure 1 shows the nine-box tic-tac-toe design of Index Strategy Boxes.

Analysis Of ETFs And Fees By Index Strategy

The classification of ETFs by Index Strategy Boxes is available at ETFguide.com. The database included data on all ETFs, exchange-traded notes (ETNs), HOLDRS, BLDRS and other exchange-traded portfolios. For this article, I screened the database for all U.S. long-only equity ETFs. The list included funds that follow broad market indexes, market size and style indexes, industry sectors indexes and thematic indexes. No inverse or leveraged funds were included. There were 304 funds in the database that matched the criteria.

I sorted the 304 funds by the Index Strategy Box information and calculated the number of funds across each of the three broad security selection methods; each of the three broad weighting methods is shown in Figure 2. I also showed the distribution of the funds within the nine Index Strategy Boxes (shaded section).

Figure 2 maps the universe of U.S. equity ETFs by index strategy. The row labeled “Passive” has 160 total ETFs. Those funds follow indexes that use a passive security selection strategy. Of the 160 funds, the 124 in the green block also follow a “Capitalization” weighting method. These are the traditional market index funds. The other 36 ETFs in the passive selection row follow alternative weighting strategies. Of those, 14 funds weight stocks using a fundamental method and 22 use a fixed-weight method. These 36 funds follow strategy indexes. The strategy is alternative weighting.

ETFs that select securities using either basic stock screens or advanced quantitative methods are highlighted in different rows. Those rows were also divided into the three weighting methods. When complete, all 304 ETFs were in one of the nine boxes.

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