ETF Guide: Mapping the ETF Landscape with Index Strategy Boxes™

The index categorization methodology briefly introduced in this paper is a new way to look at the index fund marketplace. The system has two stages of analysis. The first step defines the purpose of an index, and the second details the index construction strategy using Index Strategy Boxes™. Incorporating these two stages will greatly reduce the time needed to analyze index based products and provide more efficiently when selecting the right products.

The first step in the analysis is to divide an underlying index by its purpose. There are two types of indexes, market indexes and custom indexes.

Market indexes are primarily measurement tools. The intent of the index provider is to measure the general price level and value of a financial market and segments of that market. As such, market index constituents are passively selected to represent the general make-up of a market, and capitalization weighted to represent the value of that market. Market index data is the basis for nearly all economic study, asset allocation decisions, and are the benchmarks for active management. They have also become a popular low-cost investment strategy.

Custom indexes are intended to be investment strategies right from their inception. They are created by investment companies and index providers for the purpose collecting fees from the products that track those indexes. Custom indexes are intentionally created not to mirror the price action and performance of market indexes. Constituents in custom indexes are generally selected using a variety of non-passive methods and/or weighted using non-capitalization methods. Products that track custom indexes typically have higher fees than products that track market indexes.

Index Strategy Boxes

The rules for index construction and maintenance are published by the index provider and are available to the public, although some providers are more forthcoming than others. Knowing how an index is constructed and maintained provides investors with insight into how an investment product that follows the index is managed.

Each index has a set of rules for security selection and security weighting. Index Strategy Boxes™ classify those construction rules along those two dimensions. The two dimensions can be illustrated on vertical and horizontal axes of Figure 1. The rules are further divided by three primary types of security selection the three primary types of security weighting, which form the nine box tic-tac-toe design. The Index Strategy Boxes™ system can be easily applied to bonds, commodities, and other asset classes.

Figure 1

The Security Selection Axis

The vertical axis of Figure 1 is Security Selection. Each row represents a primary strategy used to select index constituents from the financial markets. The categories are passive, screened, and quantitative. Indexes that fall into each category typically have one of the security selection methods found in Table 1.

Table 1 – Sample Security Selection Categories and Methods

Passive	Screened	Quantitative
- Full Replication	- Fundamentals	- Economic Cycles
- Sampling Strategies	- Exchange Listing	- Forward Estimates
- Buy & Hold	- Thematic	- Momentum /Technical
- Single Securities	- Social Responsible	- Multi-factor

Source: Portfolio Solutions, LLC

Passive security selection replicates a broad market, a segment of that market, or a single security such as gold. Screened indexes filter through lists of securities, with the intent of weeding out unwanted issues. Quantitative security selection relies on computer modeling to isolate a small number of potentially superior investments.

The Security Weighting Axis

Once securities are selected for an index, they need to be given a weight in the index. The horizontal axis of Figure 1 classifies weighting methodologies into three categories: capitalization, fundamental, and fixed weight. Examples of weighting methodologies are shown in Table 2.

Table 2 – Sampled Security Weighting Categories and Methods

Capitalization	Fundamental	Fixed Weight
- Full Cap	- Dividends	- Equal Weight
- Free Float	- Financial	- Modified Equal
- Constrained	- Security Prices	- Leveraged
- Liquidity	- Momentum	- Short (inverse)
- Production	- Qualitative Factors	- Long/Short

Source: Portfolio Solutions, LLC

A capitalization-weighted index allocates each security based on its relative market value compared to all other securities in that index. A fundamentally weighted index uses financial data or qualitative factors to allocate among index constituencies. Fixed weighting assigns a set weight to each security in an index or sectors within the index. Leverage, short, and long-short funds are also considered fixed-weighted indexes because the entire index value is changed by a fixed amount.

Using Index Strategy Boxes

Until now, finding and understanding index construction methodologies has been a laborious task. Many explanations offered by index providers and fund managers are vague or difficult to comprehend. Index Strategy Boxes™ data helps investors and advisors quickly identify index strategies and pinpoint appropriate investment products. The ETF Book published by Wiley is an excellent way to learn more. For free access to a database that list comprehensive Index Strategy Box data, visit www.ETFguide.com.

Richard Ferri, CFA, is founder and CEO of Portfolio Solutions, LLC, in Troy, MI. He is a nationally know writer and writer on index investment strategies. His firm manages approximately $1 billion in index based portfolios for individual investors and clients of financial planners. Email address: Rick@PortfolioSolutions.com