Not All Index ETFs Are the Same

If you look into ETFs, you’ll find that many of them are passive ETFs that follow an index. While many index ETFs might be familiar—they track market-based indices like the S&P 500—there are other types of index ETFs as well, including proprietary and smart beta.

It's important that you understand what kind of index you’re investing in, how it works, the ETF’s expenses and, most importantly, if the indexing approach is right for your portfolio.

Here’s a look at some prominent kinds of index ETFs.

Market-based index ETFs

There are a number of ETFs that track market based indices like the S&P 500, the Russell 2000, and the MSCI EAFE, among others.¹ These ETFs give you exposure to a broad swath of the market easily and (usually) cheaply, enabling you to just about match the performance of that segment of the market.

The difference between the performance of these ETFs and the indices they follow comes largely from the expense ratio. The performance of every market index ETF will lag the underlying index by the amount investors have to pay for it. That’s why you probably want to focus on ETFs with low expense ratios.

It’s important to understand the underlying market index being tracked by the ETF. Even among the same asset class and same type of index ETF, there can be important differences. For example, among small cap blend ETFs, there are three different small cap blend market indices they follow.

• The CRSP US Small Cap Index, an index of about 1,400 small companies
• The S&P Small Cap 600
• The Russell 2000 index

A small cap blend ETF might perform better or worse depending on which index it follows. That’s why it’s important to look at the underlying market index to make sure it tracks the investments you’re trying to incorporate into your portfolio.

Proprietary index ETFs

A proprietary index is designed, monitored and maintained by a specific entity. An ETF provider then creates a passive ETF following that index. While market index ETFs usually follow a specific asset class, proprietary indices may cross asset classes or investment types.

Proprietary indices are often designed by an investment manager who wants to offer investors access to what they believe are exceptional holdings, instead of having them settle for standard market-based indices like the S&P 500.

Because proprietary indices can be constructed however the creator wants them to be, there may or may not be a solid underlying structure or process. If you’re interested in an ETF using a proprietary index, be sure you understand how the index is constructed and maintained, including how and how often it’s rebalanced to the underlying index. Most of all, be sure the index itself makes sense to you as an investor.

Factor or smart beta ETFs

Smart beta ETFs are a variation on proprietary indices. Smart beta or factor-based ETFs² are ETFs that weight the underlying holdings on factors other than market capitalization, which is how many market indices are weighted. Some typical smart beta factors include:³

• Low volatility ETFs typically include stocks in companies whose price volatility has traditionally been lower than market averages.
• Momentum ETFs weight stocks based on the momentum they’ve exhibited over a specified period, with the expectation that the stocks included in a momentum-factor ETF will maintain this momentum going forward.
• Quality ETFs weight stocks based on the strength of certain balance sheet characteristics. Examples might include low debt ratios and high levels of return on equity. Companies with excessive levels of debt on their balance sheet would generally be excluded here.
• Value ETFs typically include stocks that are undervalued compared to fundamental metrics, such as their price-to-earnings ratio.
• Fundamental ETFs weight stocks in the portfolio based on fundamental accounting factors such as revenues, cash flow, and dividends.
• Equal weight ETFs take an index like the S&P 500 and weight each of the stocks equally, whereas the original index weights them based on market cap. Equal weighting can provide protection against a downturn in one of the index's larger weighted sectors.

At their best, smart beta ETFs offer lower costs than active ETFs and the discipline of passive management. However, it's important for investors to remember that not all smart beta strategies are created equally. Some possible risks of smart beta ETFs include:

• Concentration risk. Depending on the factor being used, the ETF could become concentrated in a market sector or industry.
• Rebalancing costs. In some cases the ETF might incur high trading costs and incur tax implications if the ETF moves in and out of positions frequently.
• Timing. Some smart-beta strategies will do well in certain market conditions and underperform in others. This can impact overall results for the ETF.
• Varying market conditions. Some market conditions may not be conducive for some factor ETFs and may lead to longer-term overall underperformance.

What should ETF investors do?

Index ETFs as a group are broad enough to offer solutions to nearly anything you’d like exposure to in your portfolio. No matter what you’re thinking of investing in, make sure you understand the underlying index and how much it will cost, as the expense ratio will affect your returns.