Friday, November 5, 2010

ETF Education : Part 1 ETF Basics and History

The Good, Bad, and Ugly of Understanding an ETF Portfolio

Like many folks, I “get” the underlying premise of ETF Index investments. The basic premise is to replicate the performance of a given “index” of securities, without the need (or expense) to actively research individual securities. For example, if I want to replicate the performance of the TSX 60 index, I only need to buy one common share of each stock that comprises the TSX 60. Seems to be simple enough, right?

Unfortunately, nothing is ever quite as simple as we would like it to be in the financial world. While ETF Index investing is not nearly as frightening as trying to evaluate hundreds of securities accurately in a timely fashion, you still need to do your homework. In the next few blogs we will look inside the world of ETF Indexes, and try to lift the hood on how they work, rather than just kicking the tires. The areas we will look at will include index construction, index history, index proliferation, ETF structures, and the increasing number of ETF strategies available to investors.

Today we will tackle "Indices"; what they are and how they impact your ETF Index Funds.

Let’s start by going back a in time a bit and discussing “indices” and how they came to be. One of the oldest and most commonly followed indices is the Dow Jones Industrial Average. This index was developed by Charles Dow in 1896 to provide investors with a timely overall measure of the performance of the U.S. markets. It was created by measuring the “average stock price” of the 12 biggest industrial firms and has expanded to include the stock of 30 of the largest companies trading on the U.S. exchanges today. The name remains unchanged but the index is not nearly as focused on “industrial stocks” as the name might imply. The lesson we learn here is that you cannot trust the name of an index to be a totally accurate reflection of what is being measured.

Much later the merger of financial service companies created the Standard & Poors Index. This index changed the weighting process to  “market capitalization” of the component companies instead of the average stock price weighting utilized by Dow.
 The lesson learned here is that not all indices use the same methodology to measure an index. You need to know both what underlying securities comprise the index AND what methodology is being used to weight the index.
Since the simple start a wide range of indices have become available to track markets big and small. In every case you need to know what is being tracked and how components are being weighted.
While in theory you can use any methodology to weight the value of an index, the common ones tend to be:

1-market capitalization ( pure or capped): market capitalization weights the components of the index by multiplying each stock price by the shares outstanding to get the market value of a firm. It then calculates the firms weighting by dividing that number by the total value of all the firms in the index. A “capped” index will generally restrict any single firm from having a weighting greater than a set value ex. 10% of the total index. This capping is valuable in situations where the index has a small number of companies in it or when a single company such as Nortel gets too big and impacts the index’s ability to provide diversification.

2-stock price average: as stated above, the Dow Jones uses the “price” of the stock to calculate the index weighting relative to the total prices of all the stocks in the index. In reality the math does get a little more complex to account for mergers and other events which disrupt pricing, but the basics hold true.

3- fundamental indexing: the London Stock Exchange and Financial Times created a company known as FTSE, which in turn developed a different weighting system commonly called “RAFI”. (research affiliates fundamental index). This weights each stock on a collection of pre-set fundamentals such as sales, book value, cash flow etc. A number of index fund providers now use their own set of fundamental analysis calculations to weight indices.

4- equal weighting: as it implies, each component of the index is treated equally, regardless of share price or market capitalization. This approach puts more emphasis on smaller companies than you would find in a market capitalized index. In general an equal weighted index would be more volatile than one that was cap weighted.

Indices have been created and tracked for over a century so how is it that ETF Index Funds are such a new phenomenon?

Well, creating, tracking. and valuation of indices has benefited from computing power. To trade effectively on an exchange the index needs to be able to provide valuations every second of every trading day: So computerized programs make index trading possible by providing efficient valuations of the underlying assets in the index.
The second thing that needed to happen was to find an innovator who was willing to break with the status quo in the securities industry. It is obviously more profitable to sell an investor 60 stocks through 60 separate trades than it is to buy one ETF unit and accomplish the same result. Similarly, it is more profitable to sell a mutual fund which pays both upfront fees and trailer fees to a broker. In 1976 Vanguard in the USA created the first index fund to track the S&P 500 Index and that opened the flood gates to the index world for fund investors.
 In 1990 Toronto was the origin of the first Exchange Traded Index Fund when TiPS was traded on the TSX to track the TSX 35 Index. That first ETF Index Fund has transformed several times to become the iShares S&P/TSX 60 of today. Vanguard in turn has become the worlds largest provider of ETF Index Funds for investors. To understand why ETF Index Funds are not more popular than mutual funds re-read the second paragraph above about profitability for advisors/salespeople!

So, we have an evolution that includes creating the concept of indices, expanding the methodology for weighting index components, turning an index into a mutual fund, and then turning the mutual fund concept into an Exchange Traded Index Unit.

Some key learning's for Investors are:
1- You cannot trust the name of the index fund to provide sufficient information to understand the fund components
2- Two ETF Index Funds tracking the same index with identical components can behave very different if the components are weighted with different methodologies.
3- It is rarely beneficial to an advisor/salesperson to recommend an ETF Index Fund over alternatives such as stocks or mutual funds.
4- Canada was home to the world's first ETF Index Fund......TiPS!

Next blog we will look at how ETF Index funds have grown in number and complexity, leading to a variety of structures that are often difficult to understand.

Sois mike