The following article is an excerpt from ETFguide’s ETF Profit Strategy Newsletter, a members only publication:
Exchange Trades Funds have created a fiercely competitive market place. Hundreds of ETFs are standing in line to capture new investment dollars thrown into the mixer. Marketing departments have mushroomed to court investors and investment advisors for their hard earned dollars.
Marketing ETFs:
Back-tested performance data is one of the most common – and arguably most effective – avenues to elevate brand new ETFs above their competition.
Some companies claim that fundamentally weighted indexes outperform standard market cap weighted indexes, while others would want you to believe that quantitatively selected indexes perform better than passive benchmarks a la S&P or Russell.
The basics behind security selection and security weighting:
As you know, the security selection and security weighting methodology to ETF investors carries as much pull as a manager’s tenure with mutual fund investors.
Traditional indexes such as Russell and S&P assign weight to index components according to their market capitalization. Due to its $413 billion market cap, Exxon Mobil (NYSE: XOM) is the most prominent member of the S&P 500 Index with a 3.89% weighting.
The Russell 1000 (iShares Russell 1000 Index, AMEX: IWB) includes the 1,000 largest publicly traded companies, no filter or screen applied. The Russell 2000 (iShares Russell 2000 Index, AMEX: IWM) includes the 2,000 largest publicly traded companies, you get the picture.
Different weighting and selection methodologies:
PowerShares offers two full lines of U. S. sector indexes, one with a different tilt on the security selection methodology, one based on a different security weighting methodology.
The PowerShares Dynamic line of indexes uses a proprietary, quantitative stock selection model. Quant based models use a rules-based approach of statistical sorting to add alpha. The index is pre-programmed to identify securities that fit a certain criteria (earnings, dividends, fundamental growth, etc.). While quant selected, all components are equally weighted.
PowerShares’ RAFI line of indexes takes a different approach. The FTSE RAFI Energy Sector Portfolio (NYSEarca: PRFE) for example, takes the largest US energy stocks (similar to the Energy Select Sector SPDRs – AMEX: XLE) and weighs them according to fundamental scores.
Chevron (NYSE: CVX), for example, enjoys a 16.22% weighting in PRFE but only a 12.22% weighting in XLE. The fundamental weighting approach of the RAFI suite of ETFs delivered above average exposure to Fannie Mae, Freddie Mac, General Motors and Ford before their share prices tumbled.
To keep things interesting, Rydex uses an entirely different approach. All index components are based on the S&P’s security selection process. The Rydex U. S. industry sector ETFs list of holdings mirrors the holdings of the popular Select Sector SPDRs. Unlike the SPDRs, Rydex weighs their components equally.
After quarterly rebalancing of the Rydex Equal Weighted Technology ETF (AMEX: RYT), Apple (Nasdaq: AAPL) carries the same weight as hardly known Ciena Corp, which makes up only 0.06% in the Technology Select Sector SPDRs (AMEX: XLK). The Rydex equal weighted sector ETFs have a mid-cap tilt and tend to perform as such.
iShares and Vanguard’s ETFs carry an old-fashioned, proven, market cap weighted engine under the hood. Securities are passively compiled and weighted according to Dow Jones or MSCI methodologies.
First Trust also offers a full line of U. S. industry sector ETFs. Their AlphaDEX methodology ranks stocks according to different growth and value factors. AlphaDEX applies a modified equal weighting to all components. This results in a hybrid mix of equal weighted and fundamentally weighted.
The First Trust Consumer Discretionary AlphaDEX Fund (AMEX: FXD) and First Trust Materials AlphaDEX Fund (AMEX: FXZ) for example rank all the stocks contained in their respective sectors. According to the score, the top 75% are selected for their index. Based on their scores, the stocks are assigned to quintiles; higher ranking quintiles receive a higher rating. Within the quintiles, stocks are equal weighted.
Varying performance results:
As you can imagine, performance for the above U. S. sector industry ETFs is all over the board. The PowerShares Dynamic Financials Sector Portfolio (AMEX: PFI) recorded a loss of only 2.63% for 2007 while the Financial Select Sector SPDRs (AMEX: XLF) tumbled 18.79%.
The Rydex S&P Equal Weight Technology ETF (AMEX: RYT) eked out only 0.98% in 2007, while the Technology Select Sector SPDRs charged ahead with a 15.19% gain.
Seven ETF families offer seven complete lines of U. S. industry sector ETFs. All of them provide 100% exposure to the same industry sector with differing results. Two series of industry sector ETFs stand out with superior performance.
As a golfer will be careful to select the right club to avoid a bogey, investors should make educated decisions to minimize losses and maximize gains.
The complete analysis of all seven U.S. industry sector families is available to subscribers of ETFguide’s ETF Profit Strategy Newsletter. Sign Up |
