When it comes to indexing options, the devil really is in the details.
All too often it seems advisors zero in on an investment theme and choose the largest or most liquid ETF in that segment without regard to the underlying index strategy. Those days should be over, because it’s pretty clear that not all index methodologies are created equal.
Looking at the slew of available ETFs that canvass the financial sector in a recent two-year period, we examined how the performance of funds tracking the same segment was affected by the methodology used to select and weight constituents. Between December 2008 and December 2010, Rydex’s equal-weighted index strategy and First Trust’s Intellidex index markedly outperformed the rest of the group.
And the biggest of the group, a market-cap-weighted offering from State Street Global Advisors, got outperformed by a revenue-weighted ETF from RevenueShares that also has a large-cap tilt. The only fund that SSgA’s Financial Select Sector SPDR (NYSEArca: XLF) beat was an ETF from PowerShares that uses a one-tiered-weighted index.
In short, making relatively minor tweaks to the same universe of stocks can produce a wide array of return patterns and risk exposures. An equal-weighted strategy will likely outperform a traditional market-cap portfolio in a rising market where growth companies outperform value. However, alternative weighting strategies tend to be more expensive than cap-weighted strategies, accelerating tracking error.
All of these nuances point to an undeniable conclusion: It’s high time that advisors and investors in general understand that different weighting schemes yield different returns and, crucially, a bit of homework will make sure investors know what they’re getting into.
How A Weighting Strategy Impacts Costs
To compare how the various index methodologies performed relative to each other, we chose one fund to represent each weighting methodology. The funds and their index strategies are:
- SSgA’s Financial Select Sector SPDR (NYSEArca: XLF), based on a market cap weighted index
- Rydex’s S&P 500 Equal Weight Financial ETF (NYSEArca: RYF), based on an equal weighted index
- PowerShares’ Dynamic Financial Sector Portfolio (NYSEArca: PFI), based on a proprietary index that uses growth and value metrics to rank companies, and then weights them equally
- First Trust Financials AlphaDEX Fund (NYSEArca: FXO), based on a proprietary index that uses growth and value metrics to rank and weight constituents from the large-cap Russell 1000 Index
- RevenueShares’ Financials Sector Fund (NYSEArca: RWW), based on a revenue-weighted index