Adviser Soapbox
ETFs In Every Aisle
Carl T. Delfeld, 11.06.06, 3:00 PM ET
As the American population crossed the 300 million mark, the number of exchange-traded funds on the market passed 300. Many investors are no doubt a bit confused as to how these ETFs differ and which ones they should pick for their portfolios.
When the rubber hits the road, there are two ETF issues that are paramount: which companies are in the ETF basket and how they are weighted. A less-than-perfect analogy would be a trip to the grocery store. With a mutual fund, immediately upon entering, you hand over your grocery cart to a fund manager who wanders through the store picking items for you. With an ETF, you hand it over to a robot that goes down the aisles selecting items based on some process, such as shelf space, nutrition or food group. Value investors might only buy items on sale.
About 90% of the ETFs out there weight the companies in the basket based on their market value. This is the number of shares outstanding times the current share price. Market-capitalization weighting of companies in indexes is the conventional norm and is widely accepted by the institutional establishment.
The largest family of ETFs on the market, Barclays' iShares, weights all of the companies in their ETFs by market cap. There is almost no chance that they will deviate from this philosophy. Recognizing the tremendous lead that iShares ETFs have built, their competitors have little choice but to innovate with other strategies to capture market share.
For example, Rydex launched in 2003 the S&P equal-weight ETF which weighs each of the companies in the Standard & Poor's 500 index equally at 0.2% each, in contrast to the top-heavy market-cap-weighted index. When the big stocks like Microsoft, General Electric or Intel soar, as they did in the late 1990s, RSP will lag--but in the difficult 2000-to-2005 period, the annualized return for the equal-weight ETF was 8.06%, versus 1.13% for the traditional index. This week, Rydex is introducing nine new U.S. sector equal-weighted ETFs that represent the different sectors that make up the S&P 500.
The Powershares ETFs take another approach. They create an index and weight companies in the ETF basket based on a model that they describe but do not disclose. Normally, they have a maximum weighting policy, which prevents large companies from dominating the basket. The weightings of companies in the Powershares ETF baskets fall between the extremes of market value and equal weight. One issue is that investors won't know for some time whether the models will yield superior returns.
Another fairly new approach is that offered by the WisdomTree family of ETFs. Wisdom Tree weights companies in their ETF baskets by their record of increasing cash dividends. This gives investors another pattern of distribution and falls between the extremes. Back-testing shows that this method has a performance advantage over market-cap weighting, but only time will tell what future performance holds. WisdomTree recently introduced 11 international sector ETFs and offers unique ETFs in areas such as international small-cap and mid-cap ETFs.
The Chartwell ETF Advisor uses a blend of these ETFs in building ETF model portfolios for members. Each family of ETFs offers a philosophy that will work best in different markets. We sold the S&P 500 equal-weight ETF some time ago and moved into a market-cap-weighted one to take advantage of the rotation to mega caps.
Think of your ETF portfolio as a cooking recipe: The ingredients do not stand alone; they need to blend well together.
Don't forget to "look under the hood" of an ETF before buying it. You certainly don't buy things in the grocery store without even looking at them.
Carl Delfeld is head of the global advisory firm Chartwell Partners and editor of the Chartwell ETF Advisor He served as a director on the executive board of the Asian Development Bank during the administration of President George H. W. Bush, and he is the author of The New Global Investor.
