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It wasn’t that long ago that indexes were used almost exclusively as performance benchmarks and barometers for stock market performance, most visible as a summary of recent activity on the evening news on in the business section of the morning paper. But over the past several years, the rise of indexing strategies and ETFs has transformed indexes into investable assets with hundreds of billions of dollars seeking to replicate these strategies.

As indexes have become more widely replicated, the indexing industry has evolved rapidly. Gone are the days when there were only a handful of benchmarks; there are now hundreds of thousands of indexes that slice and dice global stock markets in almost every conceivable way. Indexes that employ unique weighting methodologies as alternatives to market cap weighting have garnered significant attention in recent years, emerging as new tools for tapping into traditional asset classes. Meanwhile, index providers have also been busy fine tuning the rules behind indexes in an attempt to enhance the experience of investors with positions in products linked to these benchmarks.

While the details and complexities of the index construction process might not make for thrilling conversation, it is obviously an extremely important topic for investors who utilize index-based products such as ETFs. As is often the case, the details matter.

Under The Hood Of Indexes

To understand how the nuances of an index methodology can translate into significant differences in a portfolio, consider two ETFs that offer exposure to Russian stocks: the iShares MSCI Russia Capped Index Fund (NYSEARCA:ERUS) and Market Vectors Russia ETF (RSX). ERUS seeks to replicate an MSCI benchmark that is designed to include the top 85% of Russian stocks by market capitalization. RSX is linked to a Market Vectors benchmark.

Though these two ETFs have considerable overlap, there are some meaningful differences in the portfolios as well that result from the features of the underlying benchmarks:

1. Single Stock Caps

Many benchmarks to which ETFs are linked now implement caps on single stocks, in part to force compliance with diversification requirements of ETFs that prevent a single stock from making up a substantial portion of the portfolio. In international markets, where a handful of companies may account for a huge portion of the total economy, that feature can help to balance out a portfolio. The indexes underlying ERUS and RSX both feature single stock caps, but at very different thresholds.

The MSCI Russia 25/50 Index to which ERUS is linked caps the weighting to any one stock at 25%; in RSX, a company is limited to about 8% of the total portfolio. As a result, ERUS is considerably more “top heavy” than RSX; Gazprom (22%), Lukoil (12%), and Sberbank (11%) combine to make up about 45% of total assets in ERUS. The top three positions in RSX make up only about 22% of assets.

The top ten holdings of RSX make up about 57% of the total portfolio; the top ten of ERUS make up close to 75% of total assets. So the methodology behind RSX results in a more balanced portfolio of Russian stocks, while ERUS is more likely to deliver a concentrated position dominated by a handful of securities.

2. Large Cap / Sector Bias

The cap on individual stocks can impact other areas of the portfolio as well, such as the sector biases and the allocations to smaller companies. Generally, higher single stock caps (or absence of a single stock cap) will result in a portfolio with greater tilts towards a single sector and higher concentration in mega cap stocks.

That’s the case with the two Russia ETFs; while both are dominated by energy stocks, the allocation to this sector is significantly higher in ERUS. That is partially the result of the lack of a cap on Gazprom and Lukoil; those two companies make up about a third of ERUS, but only about 15% of RSX. The lower single company cap in place in the index underlying RSX results in a much lower allocation to the energy sector, as well as a smaller weighting afforded to giant cap stocks. Though RSX is comprised almost entirely of mega cap and large cap securities, there is a slightly bigger weighting given to mid caps:

ERUS RSX
% Mega Cap Stocks 60% 39%
% Energy Sector 52% 35%

3. Depth Of Exposure

The depth of exposure offered by an index can obviously be another factor that determines the composition of any ETFs linked to that benchmark. And in many cases, the depth of an index can vary dramatically from index to index. ERUS, for example, holds only about 25 stocks since that is the extent of the underlying index. RSX has almost twice as many holdings, which results in a deeper and more balanced portfolio (and also contributes to the more significant allocation to mid cap stocks).

4. Who’s In / Who’s Out

The indexes on which ERUS and RSX are based have quite a bit in common; both include many of the largest Russian companies. But there are a few differences in the underlying portfolios that result from nuances in the construction methodologies. Vimpelcom, one of Russia’s largest cell phone companies with a market cap of about $18 billion, isn’t included in ERUS. The company derives most of its revenues from Russia, but has its primary listing in Frankfurt (it’s also traded on the NYSE under the ticker VIP).

Verdict

There is, of course, no universally superior indexing methodology; different approaches to creating a benchmark will perform better in different environments. For example, when the energy sector is surging and oil and gas prices are climbing, ERUS might be expected to outperform RSX thanks to the large allocation to this sector of the market.

But it’s also clear that these finer points of the index construction process translate into differences in realized returns and volatility; ERUS and RSX are clearly not identical in terms of performance.

Disclosure: No positions at time of writing.

Click here to read the original article on ETFdb.com.

Source: ETF Investors: What's In Your Index?