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Know Thy Index

Finding Fidelity

Know Thy Index

By Ron DeLegge, Editor - August 1, 2007

 

Once upon a time, the ETF landscape was an easy place to navigate.

 

There were a handful of funds and the indexes being tracked were relatively straight forward. It was hard to confuse a small cap index fund for something else. But not anymore.

 

With each passing day, the ETF industry moves further and further away from its original roots of traditional index investing. Indexes that attempt to outperform traditional benchmarks have now crashed the party. Whether it's good or bad is strictly a matter of preference, but it's clear there's no going back. Index investing isn't what it used to be, so knowing your index is a mandatory task for all ETF investors.

 

Here's a few basic questions to ask about your index:

  • Who is the company or index provider behind the index?

  • What does the index invest in? Stocks? Bonds? Commodities? Derivatives?

  • What kind of real life performance track record does the index have?

  • Is the index trying to match a benchmark or outperform a benchmark?

  • How many holdings are inside the index?

  • How often is the index rebalanced or reconstituted?

  • How is the index weighted? By market capitalization? By fundamental measures? By dividends? Or, is it equal weighted?

  • Does the index compliment your other portfolio holdings or is it needless replication?

And perhaps, the most important question you should ask is this: Does the indexing approach agree with your investment philosophy?

 

On the matter of historical performance, many recently launched ETFs are following new indexes that haven't stood the test of time. Knowing this, some fund companies are only able to present back tested or simulated performance assumptions had the index existed. While back tested data is nice, it's not real life historical performance. Nor is it indicative of what will happen in the future. Make sure you understand this.

 

As the ETF marketplace continues to evolve, the complexities will likely increase. Therefore, knowing the formula and strategy behind your index will be a crucial aspect of ETF investing.

 

The good old days are long gone.

        

 

 

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