By: Julia Aidan
Submitted: 2011-07-08 21:47:33 | Word Count: 437
Exchange-traded funds are benchmarked to an expanding universe of indexes. Those indexes range from traditional passive benchmarks that use capitalization weighting, to sophisticated quantitative strategies and alternative weighting methods. This article links index strategies to ETFs expenses. There is clear evidence that ETFs following more sophisticated index strategies charge higher fees than ETFs following passive market benchmarks. I use a new database at ETFguide.com to classify ETFs by index strategy and create a unique pricing model for ETFs based on index strategy. The model enables investors to compare the expenses of ETFs with like strategies, and guide ETF providers toward a sound pricing model.
Index Classification Terminology
Indexes can be classified by basic purpose and specific strategy. There are two basic types of indexes. A market index is a traditional "plain vanilla" measure of market value that uses passive security selection and weights securities based on market capitalization. To the contrary, a strategy index is a technique for investing in the markets rather than a measurement of market value. In a sense, market indexes track market "Beta," and strategy indexes attempt to create some type of "Alpha," either in financial terms or in expressive terms such as with socially responsible indexes.
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Market indexes are designed to measure the performance of financial markets. They are characterized by passive security selection and capitalization weighting. Security selection can include the entire universe of securities, a sampling of securities or one item such as the price of gold. Capitalization weighting can be in the form of full float, free float, liquidity or production weighting. The primary purpose of market indexes is tied to measurement, not performance. They provide a measurement of market risk and return, which can be summed up as beta.
Strategy indexes are investment strategies. They are custom-made to seek "Alpha" in the marketplace in whichever way their creators define alpha. ETF companies that use strategy indexes often imply that their products offer something better than ETFs that follow market indexes. WisdomTree promotes their fundamental strategy indexes as "Built differently, with the goal of higher returns with less risk." PowerShares claims their ETFs offer "exceptional asset management tools" through the replication of "enhanced indexes."
There is a clear link between the complexity of index strategy and the fees ETF companies charge for products. It is important for investors and advisors to understand this relationship when analyzing competing products.
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