Most exchange-traded funds (ETFs) attempt to track the performance of an index. Accordingly, knowing how those indexes are constructed and maintained is an important part of choosing the right ETF investment.
Types of Indices
There are two basic types of indices: indices that track the overall market, such as the S&P 500 Index, and indices which track a much more targeted subset of the overall market, such as small cap growth stocks or large cap value stocks. There are also indices on bonds, commodities, and currencies.
An index–based ETF seeks to earn the return of the market or subset of the market that it aims to replicate, less the fees. It should be noted that index ETFs do not perfectly track the underlying index; there is usually some level of tracking error, which is the difference between the ETF market price and the net asset value of the fund.
Generally speaking, indices based on a subset of the market are compared to and compete with more broad-based indices. Thus, investors typically will compare, say a small cap index, with a broader index on the overall market.
Indices are designed to measure, as closely as possible, the value of a specific financial market or segment of that market. They are stable baskets of stocks, bonds, commodities, or other assets whose overall price level, risk, and return are used as standard measurements worldwide. Indices represent the universe of opportunities that all investors have to choose from in the weightings that actually are available in the marketplace. Every index should be readily replicated by an investor using the rules set forth by the index provider.
The securities in an equity index generally are passively selected and capitalization weighted. Typically, index providers include a broad selection of securities and attempt to limit the turnover of those securities. Some indexes include all securities available on the public markets while others use a sampling of those securities.
Many popular market indices do not hold all the securities on the broad market. However, they do hold enough securities that are sampled from the market to qualify as a market index. Sampling methods can be optimized in an attempt to track the broad market as closely as possible. For example, the Standard & Poor’s (S&P) 500 Index does not hold all large-cap stocks, although it holds enough securities so that the index exhibits close to the risk and return characteristics of a broad basket of large-cap stocks.
The selection of securities in an index cuts across all securities exchanges. For example, Standard & Poor’s, Morgan Stanley Capital International, Frank Russell & Company, and DJ Wilshire equity indices exhibit a good cross-section of securities. Those indices are composed of stocks listed on the New York Stock Exchange (NYSE) and the over-the-counter market (NASDAQ). Although each exchange has its own indices that measure the return of securities that trade primarily on that exchange, those strategy indices are not designed or intended to measure the value of the broad securities market, regardless of where those securities trade. Equity indices are capitalization (cap) weighted. Each stock in a cap-weighted index is weighted in proportion to its market value relative to all other companies in the index. By default, a large company will have more influence on index performance than a small company.
There are many types of cap-weighted indices, including full cap, free float, capped, and liquidity. The difference between full cap and free-float is that the former includes the value of all securities outstanding while the latter only includes that portion of securities that are available to individual investors. They represent the shares held by stockholders who are at liberty to sell. For example, a full-cap U.S. large-company index includes the market value of all Microsoft shares outstanding; a free-float U.S. large-company index does not include the market value of restricted Microsoft stock personally held by company executives. By eliminating shares that are not available to trade, free-float indices reflect the universe of securities available for purchase by all investors on the open market.
Liquidity indices are a relatively new idea. Stocks are weighted on the basis of the amount of shares that trade regularly rather than free float. The evolution in liquidity indices is driven by emerging markets, where the liquidity of some issues is too thin despite a sizable number of outstanding shares.
Why Should I Consider an Index ETF?
There is a school of thought, backed by voluminous research, that argues that individual investors do best by investing in low-cost market indices and adjusting their allocation between stocks, bonds, and other assets in accordance with their age and changing risk/reward profiles. If you subscribe to that way of thinking, index-based ETFs can be very useful.
Other advantages of broad-based index ETFs include:
• Less volatility than industry-specific and strategy-specific ETFs because they hold a wider variety stocks
• The bid-ask spreads on popular index ETFs tend to be quite tight, so orders can be filled easily and efficiently
• Index ETFs tend to be among the lowest-cost ETFs because there is minimal portfolio turnover and minimal research costs
Of course, no investment is without risk. With index ETFs, investors are locked into the performance of the underlying index. If the index underperforms, so will the ETF. In addition, not all ETFs tracking the same index perform exactly alike. Due to tracking error, performance may vary, sometimes as much as half a percentage point. In selecting an index ETF, investors should assess fees, liquidity, and tracking error before making a final decision.