The mushrooming ETF market has spawned a new breed of indexes that represent a radical departure from traditional benchmarks in both their construction and purpose. With more than 500 exchange-traded funds now available in the U.S., many of them based on indexes that did not even exist two years ago, deciding where to invest is no longer simply a matter of comparing expense ratios among a dozen or so funds that share a common benchmark.
"Over the last couple of years, financial advisors have come to understand the need to conduct due diligence on indexes, just as they have done for many years with actively managed funds or separate accounts" observes Robert Brooks, national sales manager for PowerShares. "It's not just about SPDRs anymore."
Consider, for example, the investment smorgasbord available to someone looking for an exchange-traded fund that specializes in stocks that pay high dividends. One possible selection would be the iShares Dow Jones Select Dividend Index Fund (DVY), which is based on an index of the 100 highest dividend-paying securities, excluding REITs, in the Dow Jones U.S. Total Market Index. Another option is the First Trust Morningstar Dividend Leaders Index Fund (FDL), an index of the highest-yielding stocks in the Morningstar U.S. Market Index, excluding REITs, with consistent records of dividend payments and the ability to sustain them in the future. Rounding out the roster of high-dividend stock exchange-traded funds are the StreetTRACKS SPDR Dividend ETF (SDY), four PowerShares ETFs, and two Vanguard ETFs, all using different indexes. Variations in index construction are reflected in one-year performance, which recently ranged from a total return of 1.75% to a high of 30.48%.
Even narrow corners of the stock market may be represented by a basket of indexes. In the alternative energy space, PowerShares offers three sector ETFs, each with a different focus and each based on different indexes. First Trust NASDAQ Clean Edge(r) U.S. Liquid Series Index Fund (QCLN) and Van Eck Market Vectors-Global Alternative Energy (GEX) were launched earlier this year. Several indexes, such as three developed by New York-based Jeffries & Co., lay the foundation for new products in the future.
The growing array of choices may leave some advisors pining for the days when they could count the number of indexes to choose from on both hands and still have a couple of digits left. Just 16 years ago there were less than 50 index mutual funds, most based on a handful of indexes. While that number had expanded to about 300 funds by the beginning of this decade, many continued to march to the same index drummer. Between 1997 and 1999 alone, fund firms launched some 40 new index funds based on the Standard & Poor's 500 index. Just about the only thing differentiating them beyond their labels were their expense ratios, and with its low cost structure, Vanguard provided a tough bogey to beat.
The introduction of exchange-traded funds laid the groundwork for the new breed of indexes that were created specifically to support certain investments. Instead of launching exchange-traded funds based on benchmarks that already existed, as the mutual fund industry had done, ETF sponsors decided to build what they considered a better mousetrap by creating their own indexes. They were designed to be a better alternative to existing benchmarks, such as the S&P 500 or Wilshire 5000, and to indexes created by their competitors.
As of the middle of this year there were more than 200 of these "custom" indexes serving as a foundation for index funds and ETFs, and at least 200 more funds are projected to be launched after review by the Securities and Exchange Commission, according to Richard Ferri, a financial advisor in Troy, Mich. and author of The ETF Book (John Wiley & Sons), scheduled for release in December. The methodology for creating them varies widely. Some differ from traditional market cap weighted indexes such as the Standard & Poor's 500 because companies claim space according to financial characteristics such as cash flow, earnings history or dividends, without regard to share pricing. Other indexes are drawn from companies with specific social or environmental concerns, or different sectors of the market. Some are created by large, well-known research companies such as Standard & Poor's, while others are the spawn of smaller niche research firms that produce only a few indexes.
These custom indexes are very different from traditional ones, observes Ferri. Market indexes are a preferred yardstick for measuring the value and return of the markets, a comparison point for active investment strategies and a basis for asset allocation decisions. By contrast, many of the new indexes represent complex, quantitatively driven strategies rather than passive benchmarks.
"Today, indexes include virtually any basket of publicly traded securities that are selected and weighted based on a set of predefined rules, and that's very different from serving as an indicator of financial market price and value. The new indexing rules are often designed as investment strategies that are created solely for commercial products." He adds that with expense ratios averaging around 70 basis points, many ETFs are more expensive than traditional index mutual funds, although their costs are significantly lower than the average actively managed fund.
Ferri is not the only one to question whether many of the new indexes fit traditional definitions of what an index is. A spokesman for ETF powerhouse Barclays Global Investors has labeled fundamental indexes a form of "rudimentary active management," while Vanguard founder John C. Bogle criticizes their value tilt. Creators of the newer indexes say they are just approaching things from a different perspective, and that traditional indexes have tilts and biases of their own.
To some, the question of whether an ETF index is really rules-based quantitative management is more of an academic exercise than a widespread concern in the real world. "In the early days, financial advisors moved to exchange-traded funds as a low-cost way to invest in established indexes," says Anthony Rochte, senior managing director, State Street Global Advisors. "But ETF growth in recent years has more to do with gaining exposure to different corners of the market, such as commodities, as well as the ability to establish short positions. Frankly, most advisors we speak to aren't concerned about whether an ETF index is really an index."
Brooks says that many advisors he speaks with use more traditional market-cap-weighted investments for efficient markets such as U.S. large cap and then use the newer ETFs for less efficient markets such as international or small cap, where they believe some form of quantitative screening can add value. They are also using the ETFs to gain exposure to "thematic" investments, such as water or clean air technology, in a tax efficient manner. "Many advisors are combining providers that use different methodologies. Indexing is undergoing an evolution and definitions about what an index is are expanding," he says.
Another issue is whether all these new indexes expand choices for investors in a way that will benefit them in the long run, or take the simplicity that once defined the strategy down a dangerously complex path. "There is certainly a group of advisors who manage ETF portfolios and welcome the opportunity to move from one index investment to another," observes Charles "Chip" Roame, managing principal at research and consulting firm Tiburon Strategic Advisors. "But most financial advisors have more choices than they need at this point. The question is whether we really need an index based on companies that begin with the letter 'B' that are based in Chicago."
Those that create some of the indexes acknowledge that while the indexing environment is certainly more complex than it was when the first ETF was introduced in 1993, it also opens up new investment opportunities. "The underlying difficulty is that there are too many ETFs with numerous subtle variations," writes Standard & Poor's chief investment strategist David Blitzer in the September/October Journal of Indexes. "Before you complain that ETFs have lost their way and are ruining themselves, recognize that a combination of indexes offers investors a fantastic variety of efficient and inexpensive index-driven investment options."
As more ETFs come to market, financial advisors who may have had only a fleeting interest in how an index is constructed will need to do more research than they have in the past if they wish to expand beyond traditional index funds. They might also consider the liquidity of the securities in the underlying index, particularly among small-cap or emerging market indexes, since this can affect premiums or discounts to net asset value. Critics say that such analysis may not always be possible, however, because some custom indexers consider this to be proprietary information and because the methodology for index construction is not always easy to track down or understand.
Despite problems such as these, Ferri believes the brave new world of indexing is a step in the right direction as long as investors understand what they are getting themselves into. "There are excellent investments that follow custom indexes and there are less desirable investments that follow market indexes. Understanding is the key. Investors will make better choices if they have a handle on the index methodologies and understand the trade-offs among index products."