S&P's new ETF Research Report offers easy-to-use analysis to help you compare ETFs.
ETFs & Index Investing
Market indexes were designed, originally, to provide benchmarks for evaluating investments. By comparing the return of an individual security with the combined return of a group of securities with similar characteristics, you can determine how the security is doing in relation to its peer group.
While they still play that role, market indexes are equally important today as the basis for index-based investments, including exchange traded funds (ETFs) and index mutual funds, whose goal is to mirror the performance of the indexes to which they're linked.
An ETF's goal is to mirror the performance of the index to which it's linked.The underlying premise of index investing is that the most efficient way to achieve the strongest long-term return is to invest in the performance of the market as represented by an index rather than trying to beat the market.
Efficiency, in this context, means more cost effective. It's generally much cheaper to invest in an index fund than in an actively managed fund or a well-diversified portfolio of individual securities because there are no professional management fees to reduce your return.
Efficiency also refers to efficient market theory — the concept that everything that's known about an investment is incorporated into its market price. As a result, the theory asserts, you can't beat the market — as represented by a market-tracking index — unless you can divine the unexpected, which is often what drives gains or losses in the financial markets.
As index investing continues to evolve, however, so do new approaches to index construction. One change is the creation of multiple, narrowly focused indexes, often subsets of a broad index, designed to track a sector, theme, or style. Another is the development of nontraditional indexes designed to outstrip rather than replicate market performance. These variations are both applauded as important innovations and critiqued as riskier, costlier, and more volatile than true indexes.
Inside Indexes
Index providers, including companies like Standard &
Poor's, Dow Jones, MSCI Barra, and Russell create and maintain indexes, which they license to financial institutions, giving them the right to use the indexes as the basis for investment products, including index mutual funds and ETFs.
Each index is constructed somewhat differently — though there are family resemblances — and conveys different information even when it tracks the same basic market as a competitor. In most cases, though, index providers introducing a new index follow the same basic steps:
- Deciding on the scope of the index
- Choosing the portfolio components
- Determining how the index will be weighted
- Establishing the criteria for changing components
- Fixing a baseline value as of a particular date
A distinctive baseline value in combination with a specific roster of components help to explain why each index's value varies from others tracking related market segments, even though they often tend to move in the same direction. It's why, on any given day, the DJIA, Nasdaq, and S&P 500 may close at very different values. Those values also help explain why a 30-point gain in one may be more dramatic than a 30-point gain in another: The percentage gains are different.
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