Exchange-traded funds make an appealing investment for many of the same reasons that their indexed mutual fund cousins do. Lately, there's been a movement to provide racier versions of ETFs. Some of these new funds are based on obscure or even newly created indexes that have limited operating histories. Before foolishly investing, it might be wise to know the differences between ETFs, which follow traditional market-cap-weighted indexes, and some of the new funds and the index variations they are tracking.
Indexing doesn't sound sexy. Mention that you hold an index fund in a casual conversation, and you might get a smile and little else. Talk about a hot new tech stock, and the buzz is significantly different. However, many an actively run mutual fund has failed to beat market benchmarks, while 2001 showed what tech stocks can do on the downside.
The investment race does not always go to the glamorous and racy. With both an indexed mutual fund and an ETF, there is usually no mystery about what you are buying; they mirror indexes and hold securities that make up the index they track. As the grandparent of index firms, Vanguard, has demonstrated, indexing offers low costs, higher tax efficiency, and instant diversification. The Vanguard 500 Index Fund (VFINX) has accumulated more than $100 billion in assets, so it seems to be doing something right.
ETFs started off as index-based products that, in most cases, were an improvement on existing index mutual funds. ETFs are now one of the fastest-growing investment products. In September 2006, the Investment Company Institute reported that ETF assets totaled $350 billion, up 35% from last year. There are well over 300 funds, and with many new funds launched this fall, their numbers may soon top 400. ETF sponsors have plans for a number of funds, some of which are already in the pipeline at the SEC. With many segments of the market filled, some of the ETFs now being launched are targeted at niche audiences.
The majority of ETFs weight the companies they hold based on their market value (shares outstanding times the current share price). Market-capitalization weighting is the conventional norm and is widely accepted. Barclays
Market-cap weighting has come under criticism. Many detractors say it loads up on those companies that are the most trendy and popular, and underweights stocks that are undervalued. Proponents of market-cap weighting say it is simply an approximation of a company's importance in the economy, as determined by the market itself. A number of the new ETFs attempt to improve upon the cap weighting used in the early ETFs.
Research Affiliates Fundamental Indexing (RAFI -- not the singer) uses measures such as book value, free cash flow, sales, and gross dividends to weight companies. ETF provider PowerShares Capital Management LLC has licensed several RAFI indexes, and has launched nine sector funds and one small-mid cap fund based on the FTSE RAFI fundamental indexes.
WisdomTree, one of the newer ETF sponsors (but already a player, with more than $1 billion in its funds), has brought out a number of funds that track "fundamentally weighted" indexes. In contrast to market cap-weighted indexes, fundamental indexation is designed to select and weight stocks by their underlying value using financial accounting measures, not price. This means fundamental indexes should avoid the huge run-ups and corrections that can significantly affect market cap-weighted indexes. Fundamental indexes have an inherent value bias because of their tendency to hold more undervalued securities than cap-weighted indexes. So when value stocks do well, expect fundamental indexes to do well, too.
In June 2006, WisdomTree launched its first 20 fundamentally weighted ETFs. Eighteen of the portfolios are weighted based on total cash dividends, and the other two are based on dividend yield. In October, the company launched another 10 funds, and it has 31 new ETFs on file with the SEC.
Claymore Securities Inc., better known for closed-end funds, recently came out with several ETFs that seek to capture the investment potential of unique strategies. Claymore funds range from the Claymore/Sabrient Insider ETF
In 2003, Rydex, a firm known for bringing creative mutual funds and ETFs to market, launched the S&P Equal Weight ETF
With many new and exotic ETFs coming to market, some based on indexes not fully tested over a full market cycle, there is a greater possibility that some investors will end up in the wrong product. Many of the new ETFs are interesting, but also potentially risky. Besides untested indexes, there's also the risk that an investor may be enticed into a fund that ends up with higher fees and turnover, and is less tax-efficient, than a typical ETF. Peter Lynch, the former Fidelity Magellan Mutual Fund manager, is famous for his simple investment principle, "Invest in what you know." ETF creators are making this a more challenging job, but if you want to manage your own ETF investments, this is an education you would be foolish (with a small f) not to invest in.
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Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own shares in any of the funds or companies mentioned in this article. The Motley Fool has a disclosure policy.
