With over 1,600 U.S.-listed exchange traded funds available on the market, an investor will often find multiple ETF options for a single investment theme, so one should take the time and review the differences to make a more informed decision.
While the majority of ETFs passively reflect the performance of an underlying index, the benchmark indices can act as a broad representation of a market and targeted segment, but other indices may be constructed with a specific investment strategy that may be completely separate. Consequently, by understanding the underlying index, an investor will better understand the ETF, writes Jonathan Beck for Seee It Market. [Why Active Fund Investors Are Looking At Passive ETFs]
For instance, the universe of potential indices can be broken down to traditional benchmark indices weighted by market capitalization and alternative indices that are customized to track a specific strategy or actively managed style. [Transparency in ETFs at Work]
The traditional benchmark indices include the big ones that many are familiar with, like the S&P 500 index. On the other hand, the alternative indices may overweight or underweight specific sectors and asset categories, adhering to a specific investment guideline based on stock factors or company fundamentals.
From there, investors can break down asset classes into categories like large-, mid- and small-cap options. Additionally, large benchmarks can be segmented into separate sector-specific indices.
In the alternative index space, investors will have to scrutinize the indices even further. For instance, Research Affiliates Fundamental Indices track companies based on factors like book value, cash flow, sales and dividends. Dorsey, Wright & Associates’ DWA Technical Leaders Indices may pull companies based on relative strength. These types of alternative indices are associated with so-called smart- or strategic-beta ETFs that track enhanced, multi-factored or fundamental indices as opposed to traditional market-cap weighted methodologies. [Winning: Smart Beta ETFs Keep Gaining Traction]
Since many of the alternative index-based ETFs have disparate strategies, investors likely find less overlapping styles in this area of the ETF space. However, when picking among competing ETFs with similar strategies, investors should also compare the funds’ costs, efficiency, liquidity and breadth. Specifically, Beck points to assets under management, expenses, holdings, tracking error, and trading spreads.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.