What Traders Should Know about ETF Families - dummies

What Traders Should Know about ETF Families

By Michael Griffis, Lita Epstein

Each of the weighting options can impact the ETFs you choose to trade. Major advisor groups create the ETFs. The ETFs from the same advisor are called a family. Each family is developed based on a set of sector rules established by the advisor for the family. Families can be developed in three ways: market-weighted, equal-weighted, or fundamentally weighted.

Market-weighted ETFs

Market-weighted ETFs are based on market capitalization and their underlying sectors. This type of weighting gives you a good exposure to the overall U.S. economy and the sectors in it. They are biased toward large-cap stocks and don’t provide much exposure to small-cap stocks. Because many sectors have only a few companies that are large- or mega-cap stocks, these types of ETFs can be concentrated in only a few companies.

ETFs are available for each of the ten major industries: consumer goods, consumer services, energy, financials, healthcare, industrials, information technology, materials, telecommunications, and utilities, as well as sectors within those industries.

As you’re building your portfolio, you should research the indexes each ETF family uses and be sure the choice of index matches your trading goals. Generally, it’s recommended that you pick one family of ETFs and sticking with that family to avoid unwanted duplication. Also, this practice will ensure you are building a portfolio with the sectors you intend to use.

Two of the largest families managing market-weighted ETFs are Barclays iShares and State Street Global Advisors. For example, Barclay’s iShares Dow Jones sector ETFs use the Dow Jones U.S. index. This index is a market-capitalization index designed to represent 95 percent of the U.S. equity market. The managers of these ETFs use the Industrial Classification Benchmark (ICB) system to determine the compositions of each sector and subsector.

The ICB classifications were jointly developed by Dow Jones and the British indexer FTSE. (FTSE also develops indexes for many country-based stock exchanges, such as the Stock Exchange of Thailand and the Cyprus Stock Exchange.) The ICB has 10 industries, 18 super sectors, 39 sectors, and 104 subsectors.

State Street Sector SPDRs, which stands for Standard & Poor’s depository receipts, use the S&P 500 as the underlying index, which includes the 500 leading companies in the United States. They use a different classification system, the Global Industry Classification Standard, to determine the composition of each sector.

This standard was developed jointly by Morgan Stanley Capital International (MSCI) and Standard & Poor’s (S&P). The GICS has 10 sectors, 24 industry groups, 67 industries, and 147 subindustries.

The GICS takes a market-orientation approach. For example, it groups consumers into two sectors, consumer discretionary and consumer staples, which both contain goods and services. This differs from ICB, which groups consumer companies by consumer goods and consumer services.

When developing a sector strategy, the market orientation can be a significant difference. Consumer staples are considered noncyclical. Consumers have to buy them no matter what’s happening in the economy. Consumer discretionary is more impacted by cycles. This would include industries like automobile manufacturers, travel companies, and restaurants. In a grouping by consumer goods and consumers services, you get a mix of noncyclical and cyclical stocks.

Understanding the sector composition is crucial for implementing a sector strategy. So always be sure to research the underlying indexes as you choose the ETFs for your portfolio. A good place to start researching indexes is at Bloomberg.com. You can click on any index listed and get a profile of the types of stocks you will find in that index.

Equal-weighted ETFs

Equal-weighted ETFs give all stocks a similar weighting no matter what size the stock. This weighting assumes that all stocks have the same impact on the index. This type of ETF outperforms a market-weighted ETF when small-cap stocks are outperforming large-cap stocks. Each of this type of sector ETF is rebalanced quarterly to maintain an approximately equal weighting among the stocks in the underlying index.

Because many more companies are small cap than are large cap, this type of ETF needs to do a lot more trading to remain in balance than one with just a few large companies. Be sure to compare your fees with the market-weighted sector ETF options. Is paying more worth it to get the exposure to small-cap stocks? When small caps are outperforming large caps, the answer is probably yes.

Two examples of this type of ETF are the Rydex S&P 500 Equal Weight Sector ETFs and the Guggenheim S&P 500 ETFs, which are both based on the S&P 500 index and GICS standard.

If you choose to work with equal-weighted ETFs, your portfolio will be biased toward small stocks and may not be representative of the overall economy. Because large-cap stocks are more representative of the economy, this type of ETF may not be a good choice for a sector strategy.

Fundamentally weighted ETFs

Fundamentally weighted ETFs are relatively new to the ETF scene. They’re based on the underlying fundamentals, such as sales, cash flow, book value, and dividends. Companies that are the largest by whatever fundamentals chosen by the ETF manager have the largest weight in the index.

Some players in this market are nine PowerShares FTSE RAFI sector ETFs. The ICB is used to determine the composition of each sector. Information technology and telecommunications have been combined into one sector for these ETFs.

A fundamentally weighted index may be more closely aligned with the overall economy than a market-weighted one because the weights of the individual companies are based on the size of the company, not just the market cap.

Fundamentally weighted indexes are so new to the market that the underlying factors being used for these ETFs have not yet been tested. You may want to watch their results initially but not use them yet to build your sector portfolio until they have been fully tested in the marketplace.