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Indexing and ETFs

A look at the major equity index providers and the ways to gain access to them through ETFs.

Michael Rawson, 09/02/2010

Because of their low costs, exchange-traded funds are increasingly seen as the optimal vehicle to obtain passive market exposure. But when it comes to obtaining that exposure, investors face myriad choices. For example, there are ETFs that follow competing indexes from providers, such as Standard & Poor's, Russell, Dow Jones, and MSCI.

While the large number of options available allows investors to fine-tune their portfolios or implement tactical trading ideas, the amount of industry jargon can seem overwhelming, particularly when there are no standard naming conventions. On top of that, the structure of indexes is not always the result of thoughtful design but is influenced by competition between index families, trial and error in determining what will be acceptable in the marketplace, and their own legacy.

Each index divides the universe in different ways and follows slightly different construction methodologies. Do these differences matter? Is it best to buy one single fund that covers the entire stock market or several funds that cover specific market-cap ranges? Is it acceptable to mix and match funds from different index providers? In this article, we will address some of these questions and provide some background information on the different indexes.

Within the ETF landscape, there are four main equity index providers offering a suite of indexes that cover the vast majority of the U.S. equities market and slice it in a number of different ways, for example, by market-capitalization range or by style. Among ETF issuers that follow these comprehensive indexes, Schwab Funds follow the Dow Jones index family, State Street offers ETF products from S&P, iShares offers ETFs that follow both Russell and S&P indexes, while Vanguard offers funds that follow MSCI. In June, Vanguard announced plans to launch additional ETFs that will cover S&P and Russell indexes.

One Size Fits All or Tailor-Made?
Perhaps the primary use of index-based ETFs is to gain passive exposure to the broad market. For an investor who prefers simplicity and low cost, a broad index ETF can replace a handful of mutual funds and provide similar exposure at a lower cost. For example, Vanguard Total Stock Market ETF VTI covers the entire U.S. equity market for an expense ratio of just 0.07%.

A more active investor can take advantage of the available subindexes to overweight certain size or style segments of the market. For example, in the Morningstar ETFInvestor Hands-Free portfolio we are trying to capture the small-cap premium, the tendency for small-cap stocks to outperform over the long term. By using Vanguard Mega Cap 300 Index ETF MGC (which has an expense ratio of 0.13%), Vanguard Mid-Cap ETF VO (0.14%), and Vanguard Small Cap ETF VB (0.14%) to gain exposure to U.S. equities instead of just one fund, we can easily adjust our allocation to each market-cap segment.

To replicate VTI, these three funds would have to be combined in proportions of 73%, 16%, and 11%, respectively, which would result in a weighted average expense ratio of about 0.13%. So, while using three funds to gain total market exposure gives us the flexibility to adjust weights, we pay a slightly higher fee. We would also incur three times the commission charges, so the single-fund approach is probably better for those with just a few thousand dollars to invest, because the fixed commission charge will eat a larger percentage of your investment.

Can We Mix and Match?
While the core indexes from each of the providers are generally similar, if you decide to use the style or size segment indexes, it is best to avoid mixing indexes from one provider with another, unless you are comfortable with the overlap that this would create. It would not make much sense to hold a large-cap Russell 1000 fund with a MSCI Small Cap 1750 fund because 33% of the MSCI is already in the Russell. Indexes from the same family are designed to avoid this overlap. This stems from the fact that there is no standard size or style definition, so what one index calls "mid-cap growth" might be "small-cap value" in another index.

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