The rapid explosion of exchange-traded funds (ETFs) has been truly amazing to watch. With almost 600 U.S.-listed funds trading and over $500 billion in assets, it's safe to say that these financial products have moved beyond a fringe movement and are well on their way to reaching mass acceptance.
Unfortunately, it's created a lot of marketplace confusion — in particular, a lack of understanding about the inner workings of the indexes behind all these ETFs. Simply put, the entire ETF industry has grown up so fast that investment research about them has failed to keep up.
A new financial tool called Index Strategy Boxes promises to change that by offering an inside peek at how ETF indexes are assembled and managed. The tool analyzes indexes from two perspectives. Stage one is to define the purpose of an index; stage two explains the index construction strategy. This new approach hopes to reduce the time spent analyzing index-based products and to help improve investment decisions.
The tool was the brainchild of Richard A. Ferri, CEO of Portfolio Solutions, which manages over $1 billion in client assets. "While the idea of Index Strategy Boxes is to map out the underlying indexes that make up the products, the ultimate goal it to give investors and financial advisors more tools to make investment decisions."
According to Ferri's' research, there are two basic types of indexes: market indexes and customized investment strategy indexes.
Market indexes have been used as measurement tools for decades. For example, the MSCI EAFE index is a popular barometer of international stocks in developed countries. The index provider selects components and weights them in order to accurately represent the value of the market being measured. Market index data is used for various reasons: economic analysis, asset allocation decisions and benchmarking actively managed funds. Pegging an investment portfolio to market indexes via low-cost mutual funds and ETFs has also become a popular investment strategy in recent years.
Customized or investment strategy indexes are not constructed as measurement tools, but rather to beat the performance of traditional market indexes. By design, such indexes typically use non-passive methodologies to select index components and employ alternative non-capitalization weighting strategies.
INDEX SRATEGY BOXESIndexes are designed with established rules for security selection and security weighting. Index Strategy Boxes aim to classify index construction rules along a vertical and horizontal axis. (See Figure 1) These rules are further sub-divided to represent three primary types of security selection and three primary types of security weighting.
The vertical axis is "Security Selection." Each row represents a primary strategy for choosing index components from the financial markets: passive, screened and quantitative. Passive security selection mimics a broad market, a focused segment of that market or a single security such as gold. Screened indexes sort through lists of securities to filter out unwanted index components. Quantitative indexes select securities with computer modeling or other sophisticated formulas to isolate a small number of potentially superior investments.
The horizontal axis considers the next important aspect of how securities within an index-based product are weighted. "Security Weightings" are classified into three categories: capitalization, fundamental and fixed weight. A capitalization-weighted index allocates each security based on its relative value compared to all other securities in that index. A fundamental weighting employs financial metrics or qualitative factors to allocate among index components. Fixed weighting assigns a set or evenly distributed weight to each security or sector within the index.
Now that we've discussed the basic tenets, let's conduct two real life applications to illustrate how it works.
POWERSHARES QQQ TRUST (QQQQ)The PowerShares QQQ Trust (QQQQ), which tracks the Nasdaq 100, is frequently misinterpreted to be a passive index. Further investigation and analytical help from Index Strategy Boxes reveal otherwise.
