“As revolutions go, the ETF revolution of the past decade or so has been considerably less violent than, say, the French Revolution. Heads haven't been chopped off, but lots of fees were. The aristocracy wasn't driven from the palace, but the small investor, for the first time in history, found himself no longer at a great disadvantage vis-à -vis (that's a French expression) the large and powerful investor.” -Russell Wild
When they were first released in the mid-1970s, index funds were a revolutionary force. And, according to chapter five of Wild’s book, “Index Investing for Dummies,” exchange-traded funds and alternative index funds have pushed the revolution further and deeper. They began emerging in the early- to mid-1990s.
ETFs, as they are popularly known, are simply another form of indexing. Like index mutual funds, they offer low costs, tax efficiency and transparency. Where they differ from index mutual funds is in their tradability; they can be bought and sold any time the market is open. Mutual funds, on the other hand, are only traded after the market closes (although buy or sell orders can be placed at any time).
Both ETFs and index mutual funds represent baskets of securities, which may be stocks, bonds or commodities. Wild pointed out that the first ETF, symbol SPY, was introduced in January 1993 and tracked the S&P 500, as did several existing index funds. Soon after, he wrote, “Then came a slew of ETFs that invested in industry sectors, such as technology stocks, healthcare stocks, or stocks of petroleum companies. And, at the same time, came ETFs that invested in different regions of the world.”
Add to that collection very narrow niches, such as firms that manufacture medical devices or build homes. The author added, “Some of the newer ETFs — actually most of the newer ETFs, for better or worse — are now tracking indexes that were created specifically just so that an ETF could track them. Talk about the tail wagging the dog! Woof.”
These new ETFs and alternative indexes also brought in a raft of products based on different weightings:
- Traditional indexes, the original products, were based on the market capitalization of their constituent securities. For example, the S&P 500 is a cap-weighted index, which is a traditional index.
- Full-cap indexes include all outstanding shares of a company, while free-float indexes include only the publicly traded shares, or the float. There are also constrained or capped indexes, which limit the amount the largest stocks may influence the index.
- Fundamental indexes (also known as enhanced indexes) refer to products based on some financial analysis measure. For example, one index includes only companies with the best price-book value ratios; others may be based on growth of dividend yield or price-earnings.
- Equal-weighted indexes are made up of companies that each get an equal share of the weighting. For example, an equal-weighted index based on 100 stocks would give each company a 1% weighting, regardless of its capitalization or other characteristics.
- Socially responsible indexes: These begin with a screening process that eliminates companies making products considered socially undesirable. Among excluded stocks: companies that manufacture guns or tobacco products. Each index will have its own unique set of criteria, based on the subjective decisions of its fund managers.
- Inverse indexes are normal indexes turned inside out. Where a traditional index would increase in value as its constituent stocks go up in price, an inverse index would go down in value. Of course, inverse indexes also do the opposite, going up when a traditional index is going down. Their backers describe them as a tool for diversification, but they are very tricky for individual investors.
- Unmanaged indexes stay the same, no matter what happens to the constituent securities. The lineup always stays the same.
- Active indexes. Aside from being oxymorons, there really are alternative indexes that are actively managed. Wild observed, “I find it perhaps ironic that the very first actively managed ETF was introduced by Bear Stearns in March 2008 — just as Bear Stearns was on the brink of bankruptcy!” However, active index funds have stuck around, though Bear Stearns did not. These indexes are created when a fund manager begins adding or subtracting stocks from a regular index fund in a bid to boost returns.
In the matter of active indexes, Wild added, “Although I find the entire idea of active indexing a bit crazy, it may actually have an edge on other kinds of active investing.” He promised to take up the issue in a forthcoming chapter.
Overall, Wild has shown there is a host of different indexing options. They may be ETFs or they may be index mutual funds, but for index investors hoping to get a bit more than the market averages, they offer potential vehicles. Knowledge of the alternatives also may be helpful for investors who find their index funds do not match the market (or a market niche).
There are far more alternatives than most of us need, but it's still better to have too many choices rather than to few. In general, most of us should stick with popular indexes that fill a category within our portfolio and remember the bedrock principle of buying the lowest-cost funds.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Indexing for Dummies: Seduced by Big Promises
- Indexing for Dummies: Why Indexing Works
- Indexing for Dummies: The Evolution of Indexes
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
