What You Didn't Know About the Indices Behind Your ETFs
The cornerstone of any ETF is the index it tracks, and while investors often pay attention to ETF performance, they frequently overlook the intricacies of these indices.
Exchange-Traded Funds (ETFs) have rapidly gained popularity for their accessibility, low cost, and diversification. However, the cornerstone of any ETF is the index it tracks, and while investors often pay attention to ETF performance, they frequently overlook the intricacies of these indices.
The goal of this article is to explore the lesser-known risks and nuances of indices behind your ETFs, so you can make more informed investment decisions.
The Foundation of ETFs - The Index
At the core of every ETF lies an index, a basket of securities that acts as the ETF’s reference point. Whether it's tracking a large-cap benchmark like the S&P 500 or a niche market like Artificial Intelligence (AI) or Uranium, the construction, maintenance, and rebalancing of these indices are critical. However, these processes are often more complicated than they appear on the surface.
Indices have evolved considerably over the decades, shifting from simple price-weighted models to complex market-cap and free-float adjusted methodologies. While most people recognize the names of indices like the MSCI World or FTSE Developed World, few understand the mechanics behind them. The apparent simplicity of “tracking the market” belies the careful calculations and discretionary decisions involved in creating and maintaining these benchmarks.
Risks You Didn’t Know About
Even though well-diversified indices like the MSCI World and FTSE Developed World are commonly used by ETFs, there are inherent risks to be aware of. Let’s dive into some specific risks highlighted by academic research and real-world examples.
Errors in Index Construction
One of the most notable examples was the inclusion of Yahoo in the S&P 500 index in December 1999. Only 10% of Yahoo's shares were available on the market (free float), but the S&P 500 used the company's total market capitalization, which gave Yahoo a disproportionately high weight in the index. This caused many funds to purchase large amounts of Yahoo stock, artificially inflating its price.
Discretion by Index Committees
Despite meeting the eligibility requirements for several quarters, Tesla was not included in the S&P 500 until December 2020, which caused confusion among investors in general, particularly those engaged in index rebalancing arbitrage. Many funds tracking the S&P 500 index missed out on Tesla's strong rally, and when it was finally included, it created significant volatility as funds had to adjust their positions too quickly.
Problems with Trading the Underlying Assets
In June 2018, MSCI decided to include China's A-shares (stocks listed on the Shanghai and Shenzhen stock exchanges) in its MSCI Emerging Markets index. However, the process was complex, as A-shares were subject to regulatory restrictions and access limitations for foreign investors. This created difficulties in index replication by funds, as not all A-shares were easily accessible, causing discrepancies in the funds tracking the index.
Technical Data Failure
A glitch like the one that happened to MSFT due to Crowdstrike Holdings (CRWD), where index providers failed to transmit their data to ETF managers or their Authorized Participants. A clear example of a technical failure related to data transmission occurred in May 2024, when the S&P 500 and Dow Jones indices experienced problems that temporarily froze real-time pricing for about an hour. This affected the ability of ETFs replicating these indices to receive updated prices and of authorized participants to create and redeem units. This caused tracking issues in funds and ETFs, as well as discrepancies in the valuation of their portfolios.
Changes in Index Sector Classification
When the Communication Services sector was created in September 2018 as part of the GICS (Global Industry Classification Standard) sector review, it led to a significant restructuring of the indices, causing several problems and challenges for ETF managers replicating these indices.
The new Communication Services sector replaced the old Telecommunications sector but with much broader coverage. This new sector included not only traditional telecommunications companies (such as AT&T and Verizon) but also tech giants that previously belonged to other sectors, such as Meta (Facebook), Alphabet (Google), Netflix, and Disney. These companies were moved from the Technology and Consumer Discretionary sectors, respectively, into the new sector.
However, this caused problems for ETF managers and their authorized participants. For ETFs tracking sectoral indices, the rebalancing was drastic. For example, ETFs tracking the Consumer Discretionary sector had to sell significant holdings in companies like Netflix and Disney, while funds tracking the Technology sector had to do the same with Facebook and Alphabet. This rebalancing process generated large transaction costs for funds and increased volatility in the prices of the involved stocks. The transfer of these companies between sectors was neither immediate nor simple. ETF managers had to adjust their portfolios to reflect the new changes, which generated additional costs. This included both the direct costs of buying and selling shares and the indirect costs from the increase in bid-ask spreads due to the high demand for these operations in the market.
Additionally, many investors who had acquired sector ETFs expecting a certain exposure found themselves with a different composition than they had expected. For example, investors in Technology ETFs lost exposure to Facebook and Alphabet, while investors in Consumer Discretionary lost key companies like Netflix. This caused confusion and forced many investors to reconsider their investment strategies.
Some ETFs replicating sectors had difficulty maintaining close correlation with their indices during the transition period. This was due to volatility and the lack of clarity regarding the exact timing of the changes, which negatively affected index tracking (tracking error) during that period.
Additional Considerations
Index Tracking Errors
Another key concern when investing in ETFs is the concept of tracking error, which refers to the divergence between the performance of the ETF and the index it seeks to replicate. This divergence is influenced by a variety of factors such as trading costs, liquidity of the underlying assets, and the timing of rebalancing. While a well-constructed ETF should closely follow its index, events like sudden market moves or changes in index composition can lead to deviations. For instance, the inclusion or exclusion of major companies can drive significant market movements, which ETFs must adapt to in real-time.
The Influence of Major Index Providers
The dominance of major index providers such as MSCI, FTSE, and S&P Global also plays a critical role in how indices are constructed and maintained. These providers have immense power, often influencing the global financial markets. Their decisions regarding which companies are included or excluded from an index, and how the index is structured, can have wide-reaching consequences for investors. Moreover, the licensing fees charged by these providers for use of their indices contribute to the overall costs for ETFs, indirectly affecting investor returns.
Index weighting
Index weighting is a critical aspect that can significantly impact an investor's portfolio performance. The most common methods include market-cap weighting, equal weighting, fundamental weighting, and value weighting. Each has its own strengths and weaknesses, depending on market conditions and the investor's goals.
1. Market-Cap Weighting
This is the traditional method of index construction, where companies are weighted according to their market capitalization (total value of their outstanding shares).
Pros
Automatically adjusts as stock prices change, meaning larger, more valuable companies naturally have more weight.
Less frequent rebalancing is required, which keeps transaction costs low.
Cons
Tends to overweight overvalued companies and underweight undervalued ones. This creates a risk of holding too much of a bubble-prone stock (e.g., Nortel during the dot-com bubble).
Skews towards growth stocks, which perform well in bull markets but can struggle when the market corrects. It effectively leads investors to "buy high and sell low" when overvalued stocks revert to their mean.
2. Equal-Weighted
In this approach, all companies in the index have the same weight, regardless of size or market capitalization.
Pros
Historically, equal-weighted indices can outperform market-cap weighted indices over long periods.
Reduces concentration risk by giving smaller companies more weight and larger companies less.
Cons
Requires frequent rebalancing, which increases transaction costs and can reduce returns.
More volatile because of the higher exposure to small-cap stocks, which tend to have more price fluctuations.
Underperforms in cases where large-cap stocks (like Apple) continue to rise, as the index forces selling of winners during rebalancing.
3. Fundamental Weighting
This method weights companies based on financial metrics such as sales, book value, cash flow, or dividends, rather than stock price.
Pros
Helps avoid overexposure to overpriced stocks by focusing on the company's economic footprint rather than its market valuation.
Has demonstrated outperformance over market-cap weighted indices over the long term due to its focus on fundamentals, which are less prone to market inefficiencies.
Cons
May not outperform in the short term, especially in bull markets driven by momentum stocks.
Slightly higher management fees than market-cap weighted indices, although still cheaper than active management.
4. Value Weighting
In a value-weighted index, companies that are considered undervalued (based on metrics like price-to-earnings or price-to-book ratios) are given more weight.
Pros
Offers exposure to undervalued companies with the expectation that their prices will appreciate over time.
Avoids the pitfalls of market-cap weighting by buying more of a stock when it is attractively priced.
Cons
Can underperform in strong growth markets, where growth stocks typically outshine value stocks.
Requires regular rebalancing to maintain the value tilt, which can increase costs.
Each of these weighting methods has a specific role depending on the investor's risk tolerance, investment goals, and market outlook. Market-cap weighting is the most popular and simplest to use but can expose investors to inflated stock prices during bubbles. Equal-weighted and fundamental-weighted indices, while potentially delivering higher returns over time, often come with more volatility and higher transaction costs.
Conclusion: Understanding What You’re Investing In
While indices may seem like straightforward tools for tracking market performance, the underlying complexities can introduce unexpected risks. By being aware of these factors, such as index construction errors, discretionary decisions, and technical glitches, investors can better assess the true nature of their ETF investments. Understanding these risks can also provide greater insight into why your ETF might not always perfectly mirror the index it aims to track.
By looking under the hood of your ETFs, you can make more informed decisions, avoiding the pitfalls that often go unnoticed until they have a significant impact on your portfolio.