With nearly 1,400 exchange traded funds and notes listed in the U.S., sometimes wading through all the choices can be a daunting task.
Most ETFs are passively managed portfolios that follow benchmarks. However, the tracking indices can use different approaches when it comes to picking and weighting stocks.
Michael Iachini, director of investment manager research at Charles Schwab Investment Advisory, said when deciding to invest in index-based ETFs, individuals need to consider the risks and costs associated with different types of index strategies.
Iachini during a call with reporters Friday said stock ETF indices fall into four main categories: market-cap weighted, equal weighted, fundamental and quantitative. Schwab offers its own ETFs.
He said investors need to understand how the fund’s index works, since its approach can have an impact on performance and the level a risk, and whether the ETF is a “good fit” for the investor.
The most appropriate indexing strategy often “depends on your investing philosophy,” Iachini said.
Market-cap weighting is the most common way for a benchmark to be constructed in ETFs and index funds, and this category is where most of the assets reside. The stock’s weighting in the index is determined by the market, and the straightforward approach features low costs and trading, and tax efficiency. Yet Iachini noted some critics of the strategy say it puts more money in overvalued stocks that have run up in price.
Meanwhile, equal weighting allots equivalent amounts in every stock in the index. This easy-to-understand methodology can involve higher costs and trading because the index needs to be periodically rebalanced to maintain the equal weighting. It also usually results in a tilt to smaller-cap stocks, relative to market-cap weighting.
Fundamental indexing represents an effort to “build a better mousetrap,” Iachini said. Tactics include weighting stocks by dividends, profits and number of employees. In other words, techniques used in single-stock analysis are applied to determine a company’s weight in the benchmark. It can involve higher fees and trading, which may trigger more capital gains distributions relative to market-cap weighting, from a tax standpoint, Iachini explained. If the fundamental factors have “predictive power,” then the ETFs have the potential to outperform.
Finally, quantitative indexes are similar in philosophy to fundamental, but they use factors that “quant” active portfolio managers employ for stocks, said Iachini. These include price and earnings momentum.