One of the key characteristics of exchange-traded funds (ETFs) is that they track indexes. In fact, even with the proliferation of new ETFs hitting the market, 93% of funds still track an index of some sort. Many investors are familiar with the major indexes (S&P 500, Dow Jones industrial average, etc.), yet not nearly as familiar with their construction. Most of the time, the ETF sponsor, fund size, tradability, cost and other factors take precedence in the due diligence process for selecting the appropriate ETF to invest in. However, there are certain features of these indexes that are important to at least be educated on. Let’s explore how indexes are constructed, and the implications for the end user of the vehicle that tracks them, the ETF.

Index construction is much more involved than most people think, especially when moving away from traditional indexes, which has been a common theme among ETFs. Indexing all starts with what is known as the parent index. The parent index is generally a broad-market index from which the constituents for the new index will be selected. The process continues by narrowing this index by various factors until it arrives at its intended function. 

Screening for Liquidity

Generally, regardless of the index’s ultimate goal, liquidity is a common screen across the universe of indexing. Most parent indexes have already been screened for liquidity; however, there may be additional and narrower screens on liquidity beyond the parent index. This process looks for securities that trade infrequently, or are in difficult-to-access markets in the case of international investing. One of the key requirements for an index is that the securities the index holds are investable, and if, for example, there are very small stocks that rarely trade, that can be problematic.

While this may seem very behind-the-scenes, which it is, the overall liquidity of the underlying constituents of an index directly translates to the kind of liquidity that can be expected out of a product that tracks that index – such as an ETF.

Once we have the universe of liquid securities at our disposal, more specific screens are applied to narrow the universe for its particular purpose. For instance, a high-dividend-yield, emerging-market ETF would narrow the global market to emerging markets, and perhaps even further to the highest yielding securities in that market. If we want to ensure companies are still able to pay their dividends in the future, we might also screen for interest coverage or quality. There are obviously way too many methodologies to discuss, but in general most indexes are managed in a highly disciplined manner – in fact, the discipline of the methodology is an important consideration in selecting one. Occasionally, there are qualitative inputs in specific indexes that may distort the level of discipline. 

The Weighting Scheme

Finally, and perhaps most importantly, is the weighting scheme. Most of us are familiar with market-cap weighting, where the largest companies receive the largest share, and even equal weighting, which is self-explanatory. However, there can be indexes weighted by the factors they are screening for, such as volatility, value, momentum and dividend yield, among (many) others.

The weighting scheme of the index (and then ultimately the ETF) can have major return implications. Take equal weighting, for instance. Last year, one particular equal-weight energy ETF lost nearly 15%, whereas the same holdings in a market-cap-weighted ETF lost just over 8%. That’s a pretty substantial return difference, and it can go both ways.  In 2013, an equal-weighted technology ETF returned over 15% more than its market-cap-weighted cousin.

While index construction methodology and weighting schemes may seem too far in the weeds for most investors and advisors, there can be a number of nuances that lead to higher or lower risk in the index and thus the ETF, as well as potential performance differences. Paying attention to the way indexes are put together can be lucrative for ETF investors.