building-models

While the advantages of ETFs are clear to many investors, they may not work out as planned. Let’s start with the basic premise: buy the broad market cheaply. But each index provider, from S&P Dow Jones to FTSE and MSCI to Russell, has its own definition of the broad market.

More than that, because indexed investments can be bought more cheaply than actively managed strategies, there is always the temptation to create more indexes. In a recent report published by IndexUniverse, Felix Goltz, Véronique Le Sourd and Masayoshi Mukai report that since 2009, the major index providers have created 139 new indexes and another 68 in association with third parties.

S&P strategist David Blitzer notes that “most new ETFs— and recently closed ones— are based on strategy indexes rather than broad-based market indexes. Strategy dominates the new issues because there are few, if any, markets left that aren’t already covered by ETFs.”

There can be good reasons for new indexes: better beta at a cheaper cost than a mutual fund, for example in fundamental indexes, or low-volatility indexes or dividend indexes. Another might be to tap areas of the market that up to now have been invisible to the broad market, such as microcaps.

But, as Brendan Conway notes in Barron’s, microcap ETFs lag actively managed funds, in part because of the drag of trading costs.

Thus, one issue in “better beta” is the cost of implementing the model. Another, well known to Canadians, is that sector indexes can be dominated by one or two stocks—such as REITs or gold producers.

There is also an issue with “cheaper beta.” It may not be diversified. To return to Goltz and company, they cite research indicating that the S&P 500 is dominated by 86 stocks, while the larger Russell 1000 is driven by 118.

Whether it’s better beta or cheaper beta, investors have to be wary about getting the model beta they want.

Scot Blythe is a Toronto-based financial writer.
Originally published on Advisor.ca