From the December 2007 issue of Research Magazine • Subscribe!

Mapping the Index Universe

The rapid explosion of exchange-traded funds (ETFs) has been truly amazing to watch. With almost 600 U.S.-listed funds trading and over $500 billion in assets, it's safe to say that these financial products have moved beyond a fringe movement and are well on their way to reaching mass acceptance.

Unfortunately, it's created a lot of marketplace confusion -- in particular, a lack of understanding about the inner workings of the indexes behind all these ETFs. Simply put, the entire ETF industry has grown up so fast that investment research about them has failed to keep up.

A new financial tool called Index Strategy Boxes promises to change that by offering an inside peek at how ETF indexes are assembled and managed. The tool analyzes indexes from two perspectives. Stage one is to define the purpose of an index; stage two explains the index construction strategy. This new approach hopes to reduce the time spent analyzing index-based products and to help improve investment decisions.

The tool was the brainchild of Richard A. Ferri, CEO of Portfolio Solutions, which manages over $1 billion in client assets. "While the idea of Index Strategy Boxes is to map out the underlying indexes that make up the products, the ultimate goal it to give investors and financial advisors more tools to make investment decisions."

According to Ferri's' research, there are two basic types of indexes: market indexes and customized investment strategy indexes.

Market indexes have been used as measurement tools for decades. For example, the MSCI EAFE index is a popular barometer of international stocks in developed countries. The index provider selects components and weights them in order to accurately represent the value of the market being measured. Market index data is used for various reasons: economic analysis, asset allocation decisions and benchmarking actively managed funds. Pegging an investment portfolio to market indexes via low-cost mutual funds and ETFs has also become a popular investment strategy in recent years.

Customized or investment strategy indexes are not constructed as measurement tools, but rather to beat the performance of traditional market indexes. By design, such indexes typically use non-passive methodologies to select index components and employ alternative non-capitalization weighting strategies.

INDEX SRATEGY BOXESIndexes are designed with established rules for security selection and security weighting. Index Strategy Boxes aim to classify index construction rules along a vertical and horizontal axis. (See Figure 1) These rules are further sub-divided to represent three primary types of security selection and three primary types of security weighting.

The vertical axis is "Security Selection." Each row represents a primary strategy for choosing index components from the financial markets: passive, screened and quantitative. Passive security selection mimics a broad market, a focused segment of that market or a single security such as gold. Screened indexes sort through lists of securities to filter out unwanted index components. Quantitative indexes select securities with computer modeling or other sophisticated formulas to isolate a small number of potentially superior investments.

The horizontal axis considers the next important aspect of how securities within an index-based product are weighted. "Security Weightings" are classified into three categories: capitalization, fundamental and fixed weight. A capitalization-weighted index allocates each security based on its relative value compared to all other securities in that index. A fundamental weighting employs financial metrics or qualitative factors to allocate among index components. Fixed weighting assigns a set or evenly distributed weight to each security or sector within the index.

Now that we've discussed the basic tenets, let's conduct two real life applications to illustrate how it works.

POWERSHARES QQQ TRUST (QQQQ)The PowerShares QQQ Trust (QQQQ), which tracks the Nasdaq 100, is frequently misinterpreted to be a passive index. Further investigation and analytical help from Index Strategy Boxes reveal otherwise.

The Nasdaq 100 aims to represent companies across a wide range of industry groups, including computer hardware and software, telecommunications, retail/ wholesale trade and biotechnology. The index includes 100 of the largest domestic and international companies listed on the Nasdaq Stock Market while excluding financial companies, which contribute a significant portfolio of capital growth to the U.S. economy. Additionally, the Nasdaq 100 excludes companies listed on competing exchanges like the Amex and NYSE Arca. None of these attributes are what one could describe as hallmarks of a truly passive index.

As a result of this analysis, the PowerShares QQQ Trust is correctly classified by Index Strategy Boxes as a screened cap-weighted index ETF. Clearly, investors and financial advisors looking for a passive cap-weighted tech-oriented index ETF should avoid using this fund and others classified in the same category. The QQQ nonsensically excludes major technology issues such as International Business Machines and Hewlett Packard simply because they're not listed on the Nasdaq Stock Exchange. How many of the people who've invested $20.5 billion in this fund are even aware of this?

On the other hand, the QQQ works well for those who want a technology cap-weighted fund that screens for stocks that are only listed on the Nasdaq.

DOW DIAMONDS (DIA)The Dow Diamonds ETF (DIA) follows the widely followed Dow Jones Industrial Average (DJIA), called an "average" because it was originally computed by adding up stock prices and dividing by the number of stocks (30). While the methodology for calculating the Dow remains the same today, the divisor has changed to preserve historical continuity. The most frequent reason for such an adjustment is a stock split.

Suppose a member of the DJIA issues one new share for each share outstanding. After this two-for-one split, each share of stock is worth half what it was immediately before. But without an adjustment in the divisor, this split would produce a distortion in the industrial average. Here is an example: Assume three stocks selling at $5, $10 and $15. Their average price is $10. Now assume the $15 stock splits three-for-one, and the stock subsequently sells for $5. Nothing has happened to the value of an investment in these shares, but the average of their prices now is $6.67, not $10. An adjustment must be made to compensate so that the "average" will remain at $10. This can be done various ways mathematically, but Dow Jones Indexes handles it by changing the divisor, or the number that is divided into the total of the stock prices. In this example, the new divisor would be 2 instead of 3.

Analysis using Index Strategy Boxes reveals a little known fact: The DJIA was the first truly fundamentally weighted index! Remember, the Dow uses the most simplistic and basic of all fundamental measures: stock prices. Unlike the S&P 500 or Nasdaq 100, which are weighted by market capitalization, the Dow weights companies by their stock price. In short, companies with the highest stock price have the greatest influence on the Dow's movements. Even though the Dow is fundamentally weighted, it can still be classified as a passive benchmark, since its indexing committee intends for it to be an "average" or "barometer" of U.S. stocks.

CONCLUSIONUnderstanding how indexes are constructed and managed is a basic requirement for all investors and financial professionals that are using or plan to use index-based financial products like ETFs. Also, index providers and ETF sponsors owe it to the investing public to shed more light on the indexing strategies behind their products. Surprisingly, many indexes lack the type of transparency that their creators claim. By using Index Strategy Boxes, financial institutions may be better able to clearly articulate the investment objectives of their products.

"What's needed is a sensible way to classify indexes so investors can easily differentiate one index fund from another," concludes Ferri. It's hard to disagree.

To the extent that Index Strategy Boxes can help to uncover the inner workings of indexes and the financial products that track them, this new financial tool will become a success. Stay tuned.

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Ron DeLegge is the San Diego-based editor of www.etfguide.com.

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