A Fresh Look at Indexing and ETFs

by: Don Dion

Over the last decade, investors have increasingly sought out ETFs as a low-cost, liquid and transparent alternative to mutual funds. The passive indexing strategies that have traditionally defined the industry have transformed in recent years, however, and a new generation of indexes are vying for inclusion with the bulk of capitalization- weighted funds.

The incredible expansion of the ETF universe has prompted two phenomena: undercutting of existing funds and development of unique indexing. In order to survive in an increasingly competitive environment, ETF issuers are finding that they can duplicate existing ETFs and charge less—a la Vanguard—or attempt to offer investors a strategy that seeks performance or enhancement.

Strategies like RevenueShares, WisdomTree (WSDT.PK), PowerShares Dynamic and First Trust actively seek to improve upon traditional notions of indexing. The differences between these strategies are perhaps best illustrated by the degree to which they are actively managed. While these indexing strategies offer a new perspective, investors should still keep in mind the key tenets of cost and transparency that have come to define the ETF industry.

Capitalization-Weighted ETFs

Capitalization-weighted ETFs still sit at the core of the ETF universe. Early funds like SPDR S&P 500 (NYSEARCA:SPY) are among the most actively traded ETFs available in the market today. These funds seek to passively replicate a major index, such as the S&P 500 or the Russell 2000, by weighting their portfolios according to each component’s market capitalization.

These ETFs are often the most inexpensive, and they tend to keep close to their benchmarks. As a result, these funds are seeking not to outperform, but rather to capture the performance of their index. Cap-weighted ETFs represent a way for investors to “stay on the highway” and invest in a bundle of companies without having to go out and buy each one.

The weakness of this strategy is that these funds tend to chase trends in the market rather than capture them. When the funds are rebalanced, the components are reweighted to mimic changes that have already occurred in market capitalization. After investors deduct fees and transaction costs, the resulting performance will likely be lower than that of the benchmark index. In addition to SPY, notable cap-weighted ETFs include Financial Select Sector SPDR (NYSEARCA:XLF) and PowerShares QQQ (QQQQ).

WisdomTree ETFs

WisdomTree has scrapped the old notions of indexing in favor of strategies that seek measures of “value.” These ETFs screen for measures like dividends, earnings or ROI. Historically, this type of approach has outperformed the market at times, effectively offering investors “more” than just the benchmark.

Ranking components by factors like dividends, however, can be a shortsighted approach. These ETFs will exclude companies or sectors that don’t meet these value benchmarks, excluding some good buys along the way. Many growth companies like biotechs and technology firms don’t pay dividends and take longer to realize their earnings potential. Investors looking to access areas of growth in their portfolios would have to diversify elsewhere.

These ETFs would be helpful to supplement an existing strategy that is growth oriented. Investors who know that they are seeking a particular segment, like dividend-heavy stocks, could purchase a WisdomTree fund and worry less about buying and selling individual stocks as dividends are adjusted. Earnings, dividends or ROI strategies, however, are not a complete investment approach on their own. Some notable funds by this sponsor include WisdomTree India Earnings (NYSEARCA:EPI), WisdomTree Pacific ex-Japan Equity Inc (DNH), and WisdomTree Emerging Markets Equity Inc (NYSEARCA:DEM).

PowerShares Dynamic and First Trust Alphadex

These “quant” ETFs are close to their actively managed brethren. PowerShares and First Trust seek to compose funds based on a variety of fundamental characteristics, like growth, stock valuation, investment timeliness and risk factors. The indexing strategies serve as a screen between the broad indexes and investors’ portfolios. While these funds are more expensive than their more “passive” counterparts, returns seek to do more than just meet the benchmark.

The drawback to these funds is that placing a screen between the index and the ETF can detract from the essential ETF tenet of transparency. Issuers take a more hands-on approach in steering these strategies, making these funds more “active.” Understanding is key when buying one of these funds, and investors should look for liquidity before jumping in. For a closer look at these strategies, PowerShares Dynamic Large Cap Growth (NYSEARCA:PWB), PowerShares Dynamic Large Cap Value (NYSEARCA:PWV) and First Trust ISE-Revere Natural Gas Index Fund (NYSEARCA:FCG) demonstrate a range of indexing.


RevenueShares offers a new twist on the old indexing strategy without aiming to change the fundamentals. This fund sponsor applies a revenue-weighting strategy to traditionally cap-weighted indexes provided by Standard & Poor’s. By allocating assets by revenue, RevenueShares seeks to “reduce the erosion of investor returns created by cap-weighting’s tendency to overweight outlier firms in the index whose stock prices have been elevated to levels beyond the company’s actual growth rate and also the tendency of cap-weighted indexes to underweight stocks that are experiencing cyclical setbacks.”

The RevenueShares line is relatively young, and it has yet to attract the volume that other, more established ETFs have. The measured pace at which RevenueShares is releasing funds is realistic, however, and this issuer seems eager to gauge demand before dumping products into the marketplace. Some of the ETFs challenging the cap-weighted approach include RevenueShares Large Cap Fund (NYSEARCA:RWL), RevenueShares Mid Cap Fund (NYSEARCA:RWK), and RevenueShares Small Cap Fund (NYSEARCA:RWJ).

The ETF industry is growing, and the new fleet of funds is looking to stand shoulder to shoulder with traditional mutual fund strategies. The complexity of these strategies continues to grow, and investors are sacrificing some transparency for the sake of returns.

Investors are demanding more from their ETFs, and the best way to use these funds successfully is in conjunction with one another. Using a variety of funds mitigates risk and accesses new sector strategies. There is a place in today’s portfolios for active and passive strategies—both mutual funds and ETFs.