The first ETF was developed to create diversified portfolios based on equity indexes. Because equities are a core asset class for investment portfolios, it is important for investors to understand the different choices available to ensure that the proper ETFs are deployed.
Broad-Based U.S. ETFs
U.S. total market and broad-based ETFs are designed to cover the whole U.S equity market. Although indexes like the Dow Jones Industrial Average or the S&P 500 are widely used, they represent only a subset of the overall market. For example, the S&P500 only covers about 75% of the U.S. market by market capitalization and it is dominated by large cap stocks.
Use of a total market ETF, therefore, allows a long-term investor to cover U.S. equities with a single ETF. Total and broad market ETFs tend to be inexpensive, with low expense ratios and fairly narrow bid-ask spreads. Because they are so broad, their volatility is generally less than that of a more focused equity ETF.
Examples of these broad-based indexes include:
- iShares Russell 3000 Index Fund (PSE:IWV)
- iShares Dow Jones U.S. Total Market Index Fund (PSE:IYY)
- SPDR DJ Wilshire Total Market ETF (AMEX:TMW)
All-World and All-World Ex-U.S.
An investor can now achieve global equity diversification by investing in one ETF. All world ETFs provide coverage on most of the stock exchanges in both developed and emerging markets. Versions of these ETF can represent the whole world including the U.S. (all-world) or excluding the U.S. stocks (all world ex-U.S.). For most U.S. investors who already own U.S. equities, an ETF that provides global coverage not including the U.S. is the preferred choice.
Examples of these ETFs include:
- iShares MSCI ACWI (All Country World Index) Index Fund ETF (Nasdaq:ACWI)
- SPDR S&P World ex-US ETF (AMEX:GWL)
Developed Versus Emerging Markets
Stocks in the developed world have considerably different characteristics than stocks in emerging countries, much like large cap stocks are different than small cap stocks. From a portfolio construction perspective, it makes sense to look at the following entities as three separate asset classes:
- Developed countries ex-U.S., such as iShares MSCI EAFE (Europe Australia , Far East ) Index Fund (PSE:EFA)
- Emerging markets, such as iShares MSCI Emerging Markets Index Fund (PSE:EEM)
- U.S. equities
Sector ETFs allow investment in the stocks of different industrial sectors. Investors can use the sector ETFs either as building blocks for a portfolio or to make specific sector bets, like investing in energy or technology stocks. Building a portfolio with sector ETFs, versus a broad based ETF, can provide for more fine-tuning of a portfolio. Another advantage is rebalancing a portfolio on a regular basis. The process of selling those sectors that have outperformed and buying those that have underperformed - a sell high, buy low strategy - can improve performance. Using sector ETFs will allow you to avoid or minimize sectors that are over valued.
Sector ETFs tend to be more expensive than the broad-based ETFs. If an investor is building a portfolio using sector ETFs, the trading costs will be greater than buying a single, broad-market ETF. When using sector ETFs, it is best to not mix the different sector families.
Examples of two families of sectors, which are based on the traditional market capitalization indexes and their underlying sectors, are:
- Baclays iShares Dow Jones Sector ETFs
- State Street Global Advisors S&P Sector ETFs
Market Capitalization ETFs
One way of looking at stocks is based on their market capitalizations. Many experts divide the market into large cap, mid cap, and small cap stocks. Rather than buying a broad-based ETF, an investor can fine tune the strategy by buying three ETFs: a large cap, a mid cap and a small cap. This approach provides for greater customization opportunities than buying just one. An investor taking this approach should not mix the family of ETFs.
Examples of market cap ETFs include:
- iShares Russell 1000 Index Fund (PSE:IWB)
- iShares Russell 2000 Index Fund (PSE:IWM)
- SPDR DJ Wilshire Large Cap ETF (AMEX:ELR)
- SPDR DJ Wilshire Mid Cap ETF (AMEX:EMM)
- SPDR DJ Wilshire Small Cap ETF (AMEX:DSC)
Growth & Value ETFs List
Investors have the choice to buy ETFs based on whether the ETF consists of value stocks or growth stocks. In general, value stocks appear relatively inexpensive based on their current fundamentals. They typically have a combination of a low P/E ratio, low price to book value, and a high-dividend yield. Growth stocks appear more expensive on those measures because they are expected to show more growth of earnings, book value, and dividends in the future. An ETF provider that covers the entire market will categorize each stock as either value or growth, so a stocks can be in only one ETF. (For more insight, read Venturing Into Early-Stage Growth Stocks and Stock-Picking Strategies: Value Investing.)
Examples of broad-based growth and value ETFs include:
- iShares Russell 3000 Growth Index Fund (PSE:IWZ)
- iShares Russell 3000 Value Index Fund (PSE:IWW)
- iShares S&P 500 Growth Index Fund (PSE:IVW)
- iShares S&P 500 Value Index Fund (PSE:IVE)
Leveraged ETFs can offer exposure to broad U.S. market indexes but with greater volatility. So, if the S&P 500 rises by 1%, for example, the ProShares Ultra S&P500 ETF (AMEX:SSO) will rise by 2%. Similarly, if the S&P 500 falls by 1%, the same ETF will drop by 2%. Unlike a regular ETF, which buys stocks in the index, the leverage ETFs use options and futures. Because futures provide more leverage than is necessary, the extra cash is used to purchase bonds, which covers the expenses of the ETF, and to pay dividends to the owners of the ETF. (To learn more, read Dissecting Leveraged ETF Returns and Rebound Quickly With Leveraged ETFs.)
Leveraged ETFs can be used by active traders to play short-term market movements. They can also be used to increase the exposure to an index without having to borrow the money. They can also be purchased in retirement accounts, which may not allow margin lending. Leveraged ETFs tend to have higher expense ratios than standard index ETFs, even accounting for their increased exposure.
Examples of leveraged ETF include:
- ProShares Ultra QQQ ETF (AMEX:QLD)
- ProShares Ultra S&P500 ETF (AMEX:SSO)
- ProShares Ultra MidCap400 ETF (AMEX:MVV)
Quantitatively based ETFs use enhanced indexing to offer investors the potential to outperform a benchmark index. The objective is to quantitatively identify a subset of stocks from an index that are expected to outperform. Quantitative indexing uses predefined rules to rank stocks based on a number of different characteristics, which can include both fundamental and technical factors. The top-ranked stocks out of the fund universe are selected to form an index. The list includes a relatively small number of stocks that are rebalanced quarterly, reflecting a change in rankings. A fundamentally-weighted index is a type of quantitative indexing, using factors such as cash flow, revenue, and earnings to weight the stocks rather than market cap. (For related reading, check out Enhanced Index Funds - Shiny Paper Or Sparkling Gift?)
One issue with using a quantitative ETF is that you do not know the stocks it holds, which can make building a properly diversified portfolio more difficult. Also, the quarterly rebalancing results in a higher stock turnover, potentially higher trading costs, and lower tax efficiency.
Examples of quantitative based ETFs include:
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