| When doing your research on ETFs, read the | | | | Each stock is initially given an equal weight, allowing |
| prospectus and information found on the issuer's | | | | you to spread your risk equally among all the |
| website. There are many different types of ETFs, | | | | stocks in the index. It also means you get more |
| depending on what the fund is tracking but also | | | | exposure to smaller and midsize companies, which |
| how the securities are weighted, whether there is | | | | often outperform the larger caps. |
| any additional risk exposure, etc. Make sure you | | | | The other issue with market cap weighting is that |
| understand what exactly you're buying before | | | | stocks that have quickly risen in price and |
| you invest. | | | | become overvalued will have higher weighting in |
| Types of ETFs | | | | the index. (The higher a stock's valuation, the |
| Index ETF | | | | higher is its market cap.) Equal weighed ETFs |
| The most common type of ETF, an index ETF | | | | avoid overweighting stocks that trade above their |
| tracks a specific US or foreign stock index (eg. | | | | fair value. |
| NASDAQ 100, FTSE 100, S&P 500, Russell 2000, | | | | To maintain equal weighting, an equal-weighted |
| etc). There is a large variety of index ETFs for | | | | ETF needs periodic rebalancing (generally done on |
| investors to choose from. | | | | a quarterly basis). |
| Sector/industry ETF | | | | This means that such ETFs (compared to |
| These ETFs represent a specific sector (industry | | | | traditional index ETFs) usually have higher expense |
| group), eg. technology, energy, materials, | | | | ratios, as well as higher bid-ask spreads (since |
| industrials, healthcare, financials, utilities, consumer | | | | they tend to be more thinly traded). As |
| staples, etc. They track the collective | | | | rebalancing involves selling stocks that have |
| performance of that industry. As with most other | | | | appreciated most, it results in higher transaction |
| ETF types, there are US as well as foreign and | | | | fees but also higher tax liability (due to realization |
| global sector ETFs. | | | | of capital gains). |
| Size-specific ETF | | | | While equal-weighted ETFs are a great addition to |
| These ETFs are defined by the market | | | | the ETF universe, they tend to be slightly more |
| capitalization of the individual stocks within. For | | | | expensive as well as less tax efficient, all of which |
| example large-cap companies (generally over $10 | | | | can result in a lower compound return. Investors |
| billion in market cap), mid-cap companies ($2 bil to | | | | need to examine carefully whether these ETFs |
| $10 bil), small-caps ($300 mil to $2 bil), micro-caps | | | | will benefit their portfolio. |
| ($50 mil - $300 mil). | | | | Fundamentally Weighted |
| Country-specific ETF | | | | While traditional indices are market cap weighted, |
| These ETFs track the performance of the | | | | fundamentally weighted ETFs offer an alternative, |
| markets of an individual country, or, in some | | | | weighting companies based on fundamental |
| cases, an entire region (eg. Eastern Europe, | | | | factors (such as book value, earnings, dividends, |
| Eurozone, Latin America, Asia, etc). There are | | | | etc). |
| numerous international ETFs listed both on US and | | | | Some ETFs are weighted to fit a certain |
| foreign stock exchanges. | | | | investment style. For instance, there is a range of |
| Commodity ETF | | | | value ETFs which select companies based on |
| Commodity ETFs track the performance of a | | | | combinations of price/earnings, price/book, price |
| commodity (eg. oil, natural gas, gold, silver) or a | | | | cash flow ratios, dividend yield, etc. |
| basket of commodities (such as precious metals, | | | | As we have seen with equal weighting, ETFs that |
| base metals, agricultural commodities, etc). | | | | are weighted other than by market cap tend to |
| Currency ETF | | | | have a higher portfolio turnover (since they have |
| A currency ETF provides investors the ability to | | | | to buy and sell holdings as prices fluctuate). This |
| track the performance of various currencies | | | | results in increased transaction costs and lower |
| throughout the world, such as the US dollar, | | | | tax efficiency; both generally apply to |
| Japanese yen, British pound, Euro, etc. (It's | | | | fundamentally weighted ETFs as well. |
| important to note that while FOREX is essentially | | | | Actively managed ETFs |
| a 24hr market, currency ETFs have a | | | | Actively managed ETFs have been around since |
| disadvantage of being available for trading only | | | | 2008 and have so far not proved very popular |
| during stock market trading hours.) | | | | with investors. These ETFs, instead of tracking an |
| Fixed income ETF | | | | index, use a manager to select the securities to |
| ETFs that track corporate bond or treasury bond | | | | be included in the fund. |
| indices. | | | | Actively managed ETFs present similar issues as |
| ETFs by weighting model | | | | traditional actively managed mutual funds... the |
| Equal-Weighted | | | | expense ratio and transaction costs are higher, |
| Most ETFs (and indices) are weighted by market | | | | and tax liabilities are higher. |
| capitalization, meaning that larger companies have | | | | Therefore, the manager has to add up enough |
| much greater representation in the index and | | | | value to make up for this. Now, as we can see |
| greater influence on the price movement. Most of | | | | with most mutual funds, that rarely happens. |
| the index's capitalization is concentrated in the top | | | | Since most managers don't do better than |
| holdings. | | | | market averages, the benefits of actively |
| A few providers now offer equal weighted (index | | | | managed ETFs may be questionable (at least until |
| and sector) ETFs, which give a broader | | | | we start to see some track record of these |
| representation of the companies within the index. | | | | funds). |