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Picking the Right Index ETF

Paul Justice, CFA

Paul Justice: Hi there. I'm Paul Justice, director of North American ETF research at Morningstar. ETFs have opened up the options for people in accessing asset classes that were really difficult to get to before. But really I think one of the best parts of the ETF industry is the low cost access to pure index funds that are widely available on the market.

Today to discuss some of the index families with us is ETF analyst, Mike Rawson.

Mike, thanks for joining me.

Michael Rawson: Thank you, Paul

Justice: So, there are so many options out there for people, and I think a great way to gain pure equity exposure, pure beta exposures, as we like to call it, is broad based index funds. There are so many choices for them out there. Could you give us an overview of some of the major index families that are available and some of the key similarities that they have with each other?

Rawson: Absolutely, for investors who are new to ETFs, the wide range of ETF options seemed a little bit daunting and overwhelming, but the one great way to use ETFs is again, that pure index beta exposure that you mentioned, and there are several different families of indexes that an investor can choose from. There is the Dow Jones family of indexes, Standard & Poor's, Russell, and MSCI.

Now the differences between those are not substantial, but typically an investor would want to try to avoid having overlapped with the one family of indexes to another. So, typically, if you have an S&P 500 fund, you may want to stick with the S&P family of funds to get your mid-cap and small-cap exposure; that way you're sure to avoid any unnecessary overlap.

Justice: What you're saying is, typically it's good to stick with that same index family once you've started?

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Rawson: Absolutely, because one person's definition of large-cap is not going to be the same as another index provider's definition of large-cap. So you do want to make sure that you don't have any unnecessary overlap. Now, in terms of the quality of the indexes: they are all very similar. For most investors, there's not going to be a substantial difference between one index or another. So, typically, they want to go with an ETF, which provides the lowest cost and also has ample amount of liquidity.

So again, investors shouldn't be too worried about making the wrong decision here. There's probably not going to be a wrong decision, as long as you're going with the low cost ETF that has liquidity, you're probably going to be better off than if you had purchased several different mutual funds, trying to get the similar type of beta exposure.

In the end, when you buy a bunch of mutual funds, it turns out that you're going to wind up looking somewhat like an index, so instead of buying a basket of high cost mutual funds, why not just buy one or two ETFs at a lower cost, which will at the end of the day give you very similar exposure or in fact, better, more targeted exposure to an index than the basket of mutual funds.

Justice: Now, if I get a manager who is very targeted in his exposure, a few holdings, and has proven himself over time, that could be a pretty good complement, but it probably won't be the lowest cost option available.

Rawson: And there is one thing we know about fund performance is that low cost is predictive of better performance in the future. So, if there is anything that an investor can control, it's the cost of investment that he is purchasing.

And again, this is where the beauty of indexes really shines is that indexes are low cost because you're not paying the overhead of having the fund manager and the team of analysts searching for profitable opportunities. You're relying on those market efficiencies to make sure that you have an efficient product through the index, and that's where the index really stands up as being a more efficiently to invest because it has lower cost, and you're benefiting from all the other analysts that are out there, that are searching for those profitable opportunities keeping the market efficient.

Justice: Now, we've talked about how some of these funds are very similar, but there are some key differences between the index families in the way they're constituted, that I think investors should be aware of and make sure that they understand the strategy that's employed because they are all a little bit different.

Rawson: Correct.

Justice: Let's take – let's start with S&P for instance, what's something in their methodology? Let's say, I'm going down the style spectrum, something that might separate that from the rest of the group?

Rawson: Sure. Once you start deviating from the core index and start going toward either growth or value style, then the differences start to become more apparent between the different index providers. For example, each of the index providers will use a series of factors to define, well, what is value and what is growth.

An interested investor might want to take a look at those methodology papers to understand what exactly is going on, but a key differentiator for Standard & Poor's is that, they use momentum to define growth and that's something they just started doing recently. And that is a little bit unique; none of the other providers, as of yet, use momentum, because momentum is something which is really not well understood, and it's almost a separate factor besides value and growth, so they are using momentum within their growth baskets.

Additionally, another thing that Standard & Poor's does, which most of the other index providers do not do is that, they use an index committee to decide when a stock is eligible for inclusion in their index, whereas, most of the other providers are more mechanical and rules-based in what they allow to be in their index or not.

At the end of the day, the indexes are very similar, but there are few minor differences, particularly as you move down into the cap range or into the style buckets, where you start to see some differences between the index providers.

Justice: They still typically remain low cost. And I mean you have to go, when you're talking about low cost, well beyond just the fee that's charged. Most of these are also very tax efficient funds, as index funds. And I think they tend to, and you can correct me if I'm wrong, they'll either stipulate the number of stocks that are going to be in the fund or, say, even in Morningstar's case, where we will just look at the market caps of all the constituents. So the market cap makes the adjustment for how represented it is in the index. Is that a fair assessment?

Rawson: Yes, the market cap, by investing in a fund which uses market cap weighting, you decrease the amount of turnover that's necessary to keep the fund in balance with the index. A fund which might use an equal-weighting, or fundamentally weighted type of index is going wind up having more turnover and potentially higher tax costs, capital gains taxes and whatnot, from using a different weighting methodology than a market cap weighting.

Justice: So, let's say I did settle on. I decided which index family I wanted to use, are there times when I could cross some of the holdings over and have it in effective manner, let's say tax planning or something like that?

Rawson: Absolutely, typically, when you sell a security within and buy a similar security back within 30 days, it triggers what's called the wash-sale rule. And if you're trying to capitalize on long-term capital gains, you may be prohibited from doing that if you trigger this wash-sale rule, but if you buy a security which is substantially similar but not identical to the security you're selling, you won't trigger this rule.

So, here's the case where you might have, let's say, a small cap S&P 600 Index fund and you might want to switch into a Russell 2000 fund, because you want to sell the S&P 600 fund and realize a tax loss, so you could harvest that tax loss, but you still want to maintain exposure to small caps. You could roll  the proceeds from your sale of the S&P 600 small-cap fund into the Russell's small-cap fund. Substantially similar, highly correlated, they're going to give you very similar exposure, but it's not going to trigger that wash-sale tax rule.

Justice: So, I'm giving up just on the purity of my portfolio construction, maybe get some overlap, but when I have to analyze the all-in cost of doing so, that can be a pretty good idea.

Well, I appreciate you joining me today, Mike. For this and other ETF news, please join us at the ETF Solution Center on Morningstar.com or at the ETFInvestor news site. Thank you.