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Mapping the ETF Universe

Having trouble understanding the differences among the rapidly growing number of ETFs? Read this.

David J. Drucker, 04/17/2008

To catch up on advisors' opportunities for indexing in the current market, I recently interviewed Rick Ferri, founder and CEO of Portfolio Solutions in Troy, Mich.

Haven't heard of Ferri? His firm manages $1 billion in index funds and ETFs for private investors,  many of whom come to them by way of financial advisors who don't manage money. He uses strategic asset allocation methods. Ferri's also written The ETF Book (Wiley, 2007) discussing the evolution of ETFs, index methodology, and ETF classification methods. So he's got a few opinions when it comes to ETFs and indexing.

Dave Drucker: Where are we now in the expansion of the ETF market?

Rick Ferri: Index investing through ETFs continues to gain momentum in all asset classes. During 2007, there was an explosion of ETFs covering several new asset classes including taxable bonds, tax-exempt bonds and commodity products. The pace won't slow in 2008 with more than 400 ETFs still in SEC registration and more than 1,000 ETFs trading on U.S. exchanges by year-end.

DD: With their popularity, it seems almost inevitable that ETF expansion will look much like that which mutual funds have gone through.

RF: Yes. Unfortunately, the proliferation of these index products has not come without a cost, namely the confusion created by an industry launching too many funds that track too many types of indexes. Indexing is not as straightforward as it used to be. Gone are the days when an index was created to measure the performance of a financial market through passive security selection and capitalization weighting. Today, new ETFs are following active investment strategies and are called "indexes" just to satisfy the long-held SEC requirement that ETFs follow an index.

DD: So what are you doing to help advisors get through this maze of new products easily?

RF: I devised an index categorization methodology as a simple way to map the ETF universe. It starts by separating indexes into market indexes and strategy indexes. The second phase sorts ETFs into nine Index Strategy Boxes, which are a quick way to visualize how the underlying index of an ETF selects and weights securities. Finally, I show the cost difference among the nine index strategies to highlight the expenses charged by ETF providers by strategy.

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