Once upon a time, the ETF
landscape was an easy place to navigate.
There were a handful of funds
and the indexes being tracked were relatively straight forward. It was hard to
confuse a small cap index fund for something else. But not anymore.
With each passing day, the ETF
industry moves further and further away from its original roots of traditional
index investing. Indexes that attempt to outperform traditional benchmarks have
now crashed the party. Whether it's good or bad is strictly a matter of
preference, but it's clear there's no going back. Index investing isn't what it
used to be, so knowing your index is a mandatory task for all ETF investors.
Here's a few basic questions to
ask about your index:
Who is the company or
index provider behind the index?
What does the index
invest in? Stocks? Bonds? Commodities? Derivatives?
What kind of real
life performance track record does the index have?
Is the index trying
to match a benchmark or outperform a benchmark?
How many holdings are
inside the index?
How often is the
index rebalanced or reconstituted?
How is the index
weighted? By market capitalization? By fundamental measures? By dividends?
Or, is it equal weighted?
Does the index
compliment your other portfolio holdings or is it needless replication?
And perhaps, the most important
question you should ask is this: Does the indexing approach agree with your
investment philosophy?
On the matter of historical
performance, many recently launched ETFs are following new indexes that haven't
stood the test of time. Knowing this, some fund companies are only able to
present back tested or simulated performance assumptions had the index existed.
While back tested data is nice, it's not real life historical performance. Nor
is it indicative of what will happen in the future. Make sure you understand
this.
As the ETF marketplace
continues to evolve, the complexities will likely increase. Therefore, knowing
the formula and strategy behind your index will be a crucial aspect of ETF
investing.
