300 Million People, 300 ETFs

As the American population crossed the 300 million mark, the number of ETFs on the market passed 300. No doubt many investors are a bit confused as to how they differ and which ones they should pick for their portfolios.

When the rubber hits the road, there are two ETF issues that are paramount: what companies are in the ETF basket and how are they weighted in the basket. A less than perfect analogy would be a trip to the grocery store. With a mutual fund, immediately upon entering you hand over your grocery cart to a fund manager and they wander through the store picking items for you. With an ETF, you hand it over to a robot that goes down the aisles selecting items based on some process such as shelf space, nutrition or food group. Value investors might only buy items on sale.

About 90% of the ETFs out there weight the companies in the basket based on their market capitalization or market value. This is the number of shares outstanding times the current share price. Market value weighting of companies in indexes is the conventional norm and widely accepted by the institutional establishment.

The largest family of ETFs on the market is iShares and all their ETFs are market cap weighted. There is almost no chance that they will deviate from this philosophy. Recognizing the tremendous lead that iShares ETFs has built, their competitors have little choice but to innovate with other strategies to capture market share.

For example, Rydex launched in 2003 the S&P equal weight ETF (RSP) which weighs each of the companies in the S&P 500 index equally at 2% each rather than the top heavy market cap weighted index. When the big stocks soar such as in the late 1990s, RSP will lag but in the difficult 200-2005 period, the annualized return for the equal weight ETF was 8.06% versus 1.13% for the traditional index. This week Rydex is introducing nine new U.S. sector equal weighted ETFs which represent the different sectors that make up the S&P 500 index.

The Powershares ETFs take another approach. They create an index and weight companies in the ETF basket based on a model which they describe but do not disclose. Normally, they have a maximum weighting policy which prevents large companies from dominating the basket. The weightings of companies in the Powershares ETF baskets fall between the extremes of the market value and equal weight. One issue is that investors won’t know for some time whether the models will yield superior returns.

Another fairly new approach is that offered by the Wisdom Tree family of ETFs. Wisdom Tree weights companies in their ETF baskets by their record of increasing cash dividends. This gives investors another pattern of distribution and falls between the extremes. Backtesting shows a performance advantage over market cap weighting but time will tell. Wisdom Tree recently introduced 11 international sector ETFs and offers unique ETFs in areas such as international small cap and mid cap ETFs.

Don’t become overwhelmed by the choices out there. The Chartwell ETF Advisor uses a blend of these different ETFs in building its model ETF portfolios for members. Each family of ETFs offers a philosophy that will work best in different markets. We sold the S&P 500 equal weight ETF some time ago and moved into a market cap weighted one to take advantage of the rotation to mega cap. You might consider Chartwell or another advisor to help you make the right choices. Think of your ETF portfolio as a cooking recipe, the ingredients need to blend well together and do not stand alone.

Don’t forget to “look under the hood” of an ETF before buying it. You certainly don’t buy things in the grocery store without even looking at them.