Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF?–Part 2: Indexing]

As ETF products expand beyond the simple market-cap indexing methodologies, fund providers have created a new breed of “smart” or “intelligent” investments products that strive to reflect customized, strategy-based Indices.

The original rules-based ETFs screened for high-dividend stocks, based on technical analysis and weighted companies by fundamental factors like earnings or valuations. The equal-weighting methodology may arguably be a form of enhanced indexing, as well.

Additionally, Rob Arnott’s fundamental indexing methodology have been successfully implemented into some Invesco PowerShares ETFs.

Now, there is a growing subset of ETFs that offer strategy-based methodology that mimic active management but passively reflect hand-tailored indices that screen for specific qualities in an attempt to beat the market. [What is an ETF? — Indexing]

For instance, the underlying benchmark index may focus on factors like public company filings relative to frequency of trades, changes in holdings of company insiders and earnings analysis based on company returns.

Companies like Direxion, Guggenheim Investments, iShares, Russell Investments and WisdomTree are carving out market share in this new investment category.

Potential investors should be aware of how these funds operate before diving in. For instance, the frequency at which the funds rebalance will affect the returns on the securities – some indices are reconstituted on a monthly basis, while others may be quarterly, semiannually or once a year.

[What is an ETF?–Part 2: Indexing]

Max Chen contributed to this article.

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