Despite all the hype over exchange-traded funds, it's important for investors to remember that there is no such thing as a "good" or "bad" ETF. It's really the index behind it that matters.
ETFs are index funds that trade continuously during market hours like stocks, thereby allowing investors to lock in a price at any moment. There are now nearly 250 ETFs with a total market value of $350 billion.
Many analysts believe that the ETF explosion is still in its early stages, as the number of new offerings keeps growing. So far this year, there have been roughly two ETFs launched per week. These newest funds not only track assorted stock indices, but also commodities like silver through the
iShares Silver Trust
and oil via the
U.S. Oil Fund
Providers looking to enter the ETF arena now face the hurdle of finding worthwhile indices to track given that the highly recognizable names have been taken. And from an investor's perspective in this crowded landscape, the question becomes, how does one differentiate between ETFs tracking similar indices?
To learn more about what makes a suitable index for an ETF,
chatted with David Blitzer, managing director and chairman of the index committee at
Standard & Poor's
TheStreet.com: What makes a good index for an ETF to track?
: Generally speaking, there are two kinds of indices -- benchmark indices and tradeable indices. Benchmark indices focus on complete coverage of an asset class, simple rules and predictable adjustments. Examples of benchmark indices are the S&P/Citigroup Global Equity Indices, the
ETFs should be based on tradeable indices. A tradeable index is one that includes liquidity in the stock-selection criteria, times index changes to reflect market events and conditions and, most of all, is actively monitored by the index provider.
is the premier tradeable index, with over $1.1 trillion tracking the index and another $3 trillion to $4 trillion benchmarked to it in pension funds, mutual funds, ETFs like the
and others employing active managers. The 500 keeps market impacts to a minimum.
Which indices should be avoided for ETFs?
Investors should avoid ETFs that track indices that are easy to game and out-trade. Why give all your gains away to the arbs? Possibly the most infamous example is the Russell 2000, where Street analysts predict the annual adds and deletes a few weeks in advance.
Are we running out of indices? It seems like there are so many out there now due to the proliferation of ETFs. Where is there still room for growth?
I doubt we're running out of indices. The keys to index creation are creativity and an understanding of the markets. Maybe we don't have enough good indices. The ETF business is competitive and getting more so. Some ETFs will be failures and the market will let these fade away. At the same time, new indices and new ETFs will keep appearing. Free market economics works and the growth of ETFs is a good example.
There is buzz around about something called "intelligent" indices. What does this mean? What is the future for such indices in ETF form?
There seem to be two debates that occasionally pin the name "intelligent" on indices. One is about different ways to weight stocks. S&P offers equal-weighted indices. We introduced a series of pure-style indices where the factors that identify a stock as growth or value also determine the stock's weight in the index.
is marketing "fundamental indices," which use financial measures like book value to weight the stocks. All these produce some interesting results, but none can be used as benchmarks because their risk-return properties are quite different from the market. Some outperform some of the time.
The other use of "intelligent" relates to the way index changes are handled and announced. From time to time, an index change allows some market players to front-run index investors and profit from the change. Some people think they have a better way to run an index to protect those investing in products tracking the index. However, the approach almost always amounts to keeping the index changes secret until long after they are made, in effect, concealing information and letting the ETF or index fund manager trade on inside information. I doubt this approach works, and it may have other regulatory issues as well.
What makes one ETF have a higher expense ratio than another? Why should one index be more expensive to track than another?
The costs of trading stocks varies from market to market and stock to stock. It is more expensive to trade in most emerging markets and usually more expensive to trade illiquid stocks in any market. Second, where there are liquid futures and options markets available, ETF managers can often use these to reduce trading costs.
There are legitimate reasons for expense ratios to vary. Fees that index providers receive are tiny fractions of the overall operating expenses. Further, these fees are determined in a competitive market, and there is substantial and growing competition among index providers.
Why are there so few fixed-income indices, and therefore fixed-income ETFs?
Fixed is different because most indices are benchmark indices covering whole asset classes or markets. Second, while almost every stock listed on the
trades every day, probably 85% of the bonds do not trade in any given week. It is a different market.
Further, for many individual investors, muni bonds are a good choice, and there are really 30 to 50 small markets, not one large market. ETFs and indices do work with on-the-run Treasuries and TIPS, and those are successful.
How have ETFs changed the landscape for index investing?
ETFs have changed the landscape in a number of ways, like making index investing more accessible and more prominent. They also put fee pressure on mutual funds. Recently, ETFs made it easier for investors to buy gold and oil on the equity markets. All in all, ETFs are a strong plus for investors.