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What Does Your Index Fund Do?

What Does Your Index Fund Do?
By Ron DeLegge, Editor
December 9, 2009

SAN DIEGO (ETFguide.com) – Behind the explosive growth of ETF investing is the explosive growth in the sheer number of indexes. And with each passing day, the ETF marketplace moves further and further away from its original roots to traditional index investing.

Today, for example, there are a multiplicity of indexes that attempt to outperform traditional benchmarks by using dividends, revenue growth and other financial factors. Many of these indexes are marketed as “passive” benchmarks, when in reality they’re making active bets. The proliferation of indexes has created a lot of investor confusion. Do you know what your index funds really do?

Asking the Right Questions
ETFs are low cost index funds that trade like stocks. However, not all indexes use the same strategy.

In his book titled, “The ETF Book” (Wiley 2009), Richard Ferri, CFA described a simple way of better understanding the indexes behind index mutual funds, index ETFs and index ETNs.

The two main questions investors should know the answer to are, 1) How the index selects securities, and 2) How the index weights the securities within it. Got it?

Next, Ferri introduces a financial tool called the “Index Strategy Boxes” which visually maps out what indexes are doing. The basic idea is to offer investors better financial disclosure and to help them to make educated and informed investment decisions.

Understanding Your Indexes
Index Strategy Boxes categorize ETFs and related products into nine grid shapes with each shape representing a specific index strategy. (See graphic image below.)

Index Strategy Boxes: A Visual Map of Index Fund & ETF Strategies

The vertical axis groups index strategies into three broad methods for selecting securities: passive, screened, and quantitative. The horizontal axis categorizes index strategies into three broad security weighting methods: market capitalization, fundamental, and fixed/equal weight.

Index Strategy Boxes enables investors to quickly identify and distinguish the differences between indexing strategies. This user friendly tool is easily applied to equity, fixed income and commodity indexes.

Practical Applications
The practical application of Index Strategy Boxes are many. For example, investors can now compare the cost and performance of indexing strategies for ETFs in various fund categories.

For instance, which index strategies in the large cap blend category are performing the best? Is it passive market cap? Or, is it screened fundamental? Index Strategy Boxes tells you the answer. Large cap blend ETFs have nine possible index strategies and can now be analyzed according to their Strategy Box classification.

Another benefit of Strategy Boxes is to help investors to understand the true cost of various indexing strategies.

ETFguide.com was the very first place that embraced the innovation of the system and moved ahead in 2007 by building a online ETF database around it. The free database reports the average cost of various indexing strategies so that investors can have a point of reference in determining the true cost of indexing strategies.   

Other Factors to Consider
Lastly, here's a short checklist of other factors to consider before investing in index ETFs:

--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?
--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?

As the ETF marketplace continues to evolve, the complexities will likely increase. Therefore, knowing the formula and strategy behind your index funds are crucial to successful investing. 

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