Having trouble understanding the differences among the rapidly growing number of ETFs? Read this.
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.
DD: What, exactly, are market indexes and strategy indexes?
RF: Market indexes measure market returns, and strategy indexes are those representing a strategy for investing in the markets addressed by each particular index product. Market indexes are primarily for measuring the value of financial markets and market segments and represent the broad universe of securities from which investors may select. They are used in all areas of global finance and are tracked by central banks and Treasury departments, and are used in research by the world's top business schools. Of course, in portfolio management, the risks and returns of market indexes form the basis for asset-allocation decisions and the yardstick against which all active management strategies are measured.
In contrast, strategy indexes are net measures of broad market returns. They are primarily created for commercial purposes--as the basis for investment products. Strategy indexes are intentionally designed not to track markets, but to function as alternative products that compete against market indexes. Strategy indexes can be created an infinite number of ways, often featuring custom security selection and modified security weighting methods.
DD: How do your Index Strategy Boxes work?
RF: Unfortunately, the rules for constructing a particular index aren't fully disclosed by all index providers; some offer excellent transparency while others provide the bare minimum required by the SEC. So we created Index Strategy Boxes as a way for advisors and retail clients to visualize the basics of index construction. The boxes give investors a quick understanding of how an index is constructed with respect to security selection and security weighting. Index Strategy Boxes characterize ETFs according to three possible security selection types and three possible security weighting types. The two dimensions are illustrated on vertical and horizontal planes, which form the nine Index Strategy Boxes.
Index Strategy Boxes
DD: It's a similar grid to the Morningstar Style Box, which is used to categorize mutual funds. Talk about the three categories for selection and weighting. How were those derived?
RF: Each row on the security selection axis (passive, screened, and quantitative) represents a primary strategy used to select index constituents from the financial markets, and indexes that fall into each category typically have one of the security selection methods found below:
|Full replication||Fundamentals||Economic cycles|
|Sampling strategies||Thematic||Forward estimates|
|Buy and hold||Single exchange||Momentum/technical|
|Single securities||Niche industry||Black box|
DD: So how do the passive, screened, and quantitative methods of security selection differ?
RF: Passive indexes may "sample" a market's securities so as to either represent the broad market or a segment of the market. This category typically includes industry sector, size, and style funds because they are direct subsets of broad market indexes. It also includes single securities that can be thought of as passive indexes that represent the price movement of one asset such as a single currency, a barrel of oil, or an ounce of gold.
DD: "Screened" implies a filtering process?
RF: That's right. Screened indexes use filters to sift through lists of securities to eliminate unwanted issues. Screens can span many different criteria including such fundamental factors as high-dividend-paying or consistent-earnings companies, thematic issues such as social consciousness and environmental concerns, or exchange preferences such as the Nasdaq or NYSE. One popular exchange-screened ETF is Powershares QQQ
Quantitative indexes rely on computer modeling to isolate a small number of potentially superior investments. ETFs that use quantitative selection strategies have much higher turnover than passive or screened indexes and higher fees, as well. Quantitative index providers are understandably reticent about the details of their "black box" methodologies; yet, whether or not quantitative methods actually work has yet to be determined.
DD: The other axis to your Index Strategy Boxes is the security weighting axis that classifies weighting methodologies as capitalization, fundamental, or fixed weight. How do those work, exactly?
RF: Capitalization weighting is the standard method for security weighting worldwide. In the United States alone, there are hundreds of capitalization-weighted stock indexes covering all corners of the financial markets. A fundamentally-weighted index relies on a single factor or set of factors other than market capitalization to weight stocks. Weighting may be based on financial data such as dividends, earnings, and earnings predictions, or it may be based on price momentum, company qualitative rankings, or a multifactor weighting method that combines several items.
Fixed-weight indexes have a fixed allocation for each constituent in an index or groups of securities in an index. There are several types of fixed weights including equal weighting of securities, equal weighting of industry segments, and modified equal weighting using multiple fixed levels. Also included under fixed weight indexes are leveraged, inverse, and long-short strategies because those strategies magnify changes in the entire market by a fixed amount. Regular rebalancing is needed to keep all fundamental and fixed weight indexes in line.
|Full cap||Financial factors||Equal weight|
|Free float||Dividend level||Modified equal|
|Production||Qualitative factors||Long/short 130/30|
DD: What do these categories imply, if anything, for performance?
RF: Different index weighting methods do lead to different performance paths over an economic cycle. Fundamental weighting generally overweights value stocks, which tend to perform best as the economy recovers from an economic slump. Fixed weight methods, such as equal weighting, shift the average market capitalization of the index lower. Consequently, an equal-weighted index should outperform a cap-weighted index when small-cap stocks outperform large-cap stocks.
DD: Describe the real-life uses for your Index Strategy Boxes.
RF: The whole idea is to help investors quickly and easily identify index strategies and pinpoint appropriate investment products. Unfortunately, finding detailed information about index construction rules is often difficult and some index providers are intentionally vague about their process. In addition, there is little standardization of the terminology. What is called a modified-equal-weight strategy by one provider may be called something different by another.
DD: Do the boxes also help users identify an ETF's expenses?
RF: Yes. We find fees tend to be similar among product providers using similar index strategies. A comparison of 304 U.S. equity ETFs, for example, shows that the median fee for a passively selected, cap-weighted ETF that follows a market index is 0.3%.
ETF expenses increase as the underlying index becomes more complex. For example, the median cost of ETFs that follow a screened index is 0.47%. If the index is screened and securities are fixed-weight, the cost goes up to a 0.58%. The expense ratio moves to at least 0.6% when the selection method is quantitative.
DD: Why are the fees higher for ETFs that follow more complex indexes?
RF: Perhaps the index providers are charging higher licensing fees for those indexes, or maybe the fund companies believe they can get a better price by adding complexity to their funds. Most likely it is a combination of both.
DD: Where can readers learn more about indexing strategies and ETF expenses?
RF: I have a more detailed study of ETF expenses as they relate to index strategy coming out in an article, "The ABC's of ETFs: Alpha, Beta and Cost," to be published in the May/June 2008 issue of The Journal of Indexing.
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