What Does My ETF Do?
By Ron DeLegge, Editor
February 4, 2009
SAN DIEGO (ETFguide.com) – Almost 100 percent of all exchange-traded funds or ETFs are designed to follow indexes. An index is merely a group of securities, like stocks or bonds. The purpose of an index is to provide investors with a tracking device that reports the collective performance of a certain market.
While there’s been much innovation in the development of new indexing methodologies within the ETF industry, there’s unfortunately been a dearth of education and research to help investors make the right ETF choices.
Do you really know what your ETFs are doing?
Before selecting the correct ETFs for your portfolio it’s vital that you have an elementary understanding of the indexes behind them. The Securities and Exchange Commission does not define the difference between market indexes and alternatively constructed indexes, so don’t expect help from them. Likewise, certain ETF providers are more concerned with publishing back-tested results and bad mouthing the indexes of their competitors than in divulging the exact investment strategy of their index ETFs. As a result, millions of ETF investors are left in lurch.
In response to this problem, ETFguide.com has released the first fully searchable online ETF database that clearly indicates the true investment strategy of index ETFs. Instead of trusting the marketing literature of enthusiastic ETF providers, we took the additional step of defining exactly what their index ETFs are doing and then classifying them accordingly. To that end, the principle ETF tool we use is ETFguide’s Index Strategy Maps. In short, the Index Maps tell us with precision how index ETFs are selecting and weighting the securities within their portfolios.
Here’s what the Index Strategy Maps tell us about three of the most heavily traded U.S. listed ETFs:
Dow DIAMONDS (NYSE: DIA)
This ETF follows the Dow Jones Industrial Average, which is a collection of 30 U.S. blue chip stocks that was started by Charles H. Dow in 1896. Companies are selected passively and then weighted according to just one fundamental measure (stock price). Dow companies with the highest stock prices will have a greater influence on the performance and volatility of this benchmark. Although just a handful of perceptive financial professionals recognize it, the Dow is actually the first fundamentally weighted benchmark. The Editors at the Wall Street Journal determine the Dow’s makeup.
In 2008, DIA declined by 32.14%. International Business Machines (7.34%), ExxonMobil (7.21%), and Chevron (7.11%) are among the Dow’s top holdings. DIA’s annual expenses are 0.18%.
--Index Strategy Map for DIA
SPDRs (AMEX: SPY)
SPY follows the Standard & Poor’s 500, a popular benchmark large cap U.S. stocks. The S&P 500 represents 76% of the U.S. equity market. This index uses a passive methodology in selecting each of its 500 constituents and then subsequently weights them according to their market capitalization. Stocks with the largest market size have a larger impact on the performance and volatility of the S&P 500. The S&P Index Committee determines which individual stocks get included or deleted.
In 2008, SPY declined by 37.38%. ExxonMobil (5.17%), Procter & Gamble (2.35%), and General Electric (2.17%) represent the fund’s three largest holdings in order. SPY’s annual expenses are 0.10%.
--Index Strategy Map for SPY
PowerShares QQQ Trust (Nasdaq: QQQQ)
This PowerShares ETF follows the Nasdaq-100, which is a popular barometer of U.S. technology stocks. The Nasdaq-100 uses a screening method for selecting stocks by limiting the selection universe to just Nasdaq-listed publicly traded companies. After stocks have been chosen, they are weighted by their market capitalization or size. Like the S&P 500, the largest stocks within the Nasdaq-100 dominate its daily movements.
In 2008, QQQQ declined by 41.67%. Apple (11.25%), Microsoft (6.24%), and QUALCOMM (6.53%) are among the fund’s largest holdings. QQQQ’s annual expenses are 0.20%.
--Index Strategy Map for QQQQ
Do you get it?
Picking the right ETFs is much more than just choosing the funds with the hottest performance. Successful ETF investing is also about context and having an informed view of what indexing strategies your funds are engaging in. As you just learned, the Index Strategy Maps are a powerful investment tool. Think of them as a quick visual reference in helping you to determine what your ETFs are really doing.
For review: The vertical axis describes how securities are being selected. The three possibilities are passive, screened, and quantitative. The horizontal axis explains how securities are being weighted. The three possibilities are by capitalization, fundamentals, or fixed/equal weight. It’s simple!
The Index Strategy Maps can be seamlessly applied to indexes in all asset classes, regardless of whether they follow an ETF, ETN, or index mutual fund product structure. ETFguide’s online database also allows users to compare the cost of indexing strategies versus each other. Which ones cost the most? Which ones cost the least? Find out.
Finally, I’d like to credit Richard A. Ferri, CFA a prolific author and the CEO of Portfolio Solutions with pioneering the concept of the Index Strategy Maps. This wonderful ETF tool is one of the few financial innovations that sheds light on the true investment strategies of index ETFs. You can read more about this in his latest book called The ETF Book (2008 Wiley).