Mapping the ETF landscape with index strategy boxes

Index investing through exchange-traded funds is booming, as is the number of offerings available. Unfortunately, investors and advisors are overwhelmed with many of the new products and are having a difficult time grasping the details of the indexes they follow.

The index categorization methodology briefly introduced here is a new way to look at the index fund marketplace.

ETFs follow indexes, and the rules for index construction and maintenance are published by the index provider. Knowing how an index is designed and maintained provides investors with insight into how the ETF is managed.

There are two basic index rules. One covers security selection and other covers security weighting. Index strategy boxes illustrate these two sets of rules using a graphical presentation (see Figure 1). Security selection appears on the vertical axis and security weighting appears on the horizontal axis. Each axis has three methods of index construction, together with three categories of security selection and three categories of security weighting. Together, they form a nine box tic-tac-toe design.

Figure 1



The security selection axis -- The vertical axis of Figure 1 represents security selection. Each row represents a primary strategy used to select index constituents from the financial markets. The categories are passive, screened and quantitative. Passive security selection replicates a broad market, a segment of that market or a single security such as gold. Screened indexes filter through lists of securities, with the intent of weeding out unwanted issues. Quantitative security selection relies on computer modeling to isolate a small number of potentially superior investments.

The security weighting axis -- Once securities are selected for an index, they need to be given a weight. The horizontal axis of Figure 1 classifies weighting methodologies into three categories: capitalization, fundamental and fixed weight. A capitalization-weighted index allocates each security based on its relative market value compared to all other securities in that index. A fundamentally weighted index uses financial data or qualitative factors to allocate among index constituencies. Fixed weighting assigns a set weight to each security in an index or sectors within the index. Leverage, short and long-short funds are also considered fixed-weighted indexes because the entire index value is changed by a fixed amount.

Until now, finding and understanding index construction methodologies has been a laborious task. The index strategy box system can be easily applied to bonds, commodities and other asset classes. The information helps investors and advisors quickly identify index strategies and pinpoint appropriate investment products.

*For further information or to contact this author, please use the forum below.