Many of you will have read about the advantages of Exchange Traded Funds over Mutual Funds. However, have you considered beyond the “ETF” moniker to ask: “What ETF index should I be looking for”?

ETF Basics

To start with, let’s quickly examine the basics of ETFs. These are generalities, but tend to hold true.

Exchange Traded Funds are managed such that the asset allocation of the fund matches the underlying index the fund is attempting to emulate. The indexes range from well known (e.g. S&P500) to obscure, created specifically for the
ETF (e.g. water focused). Management fees are generally less than 0.5%, but can be higher for specialized funds. ETFs trade daily on the stock exchange and can trade at a premium or discount to the underlying assets. Through fancy footwork, ETFs generally retain profits within the fund and make only small distributions each year.

As you can guess, I am a fan of ETFs. I previously held an actively managed mutual fund. While it performed well and has an excellent reputation, the distributions I reinvested each year were killing me, as I paid the tax out of my own pocket. Not only that, I was paying 1.5% a year in management fees, on top of administration fees. Due to this, I often only just outperformed the MSCI international index, before tax!

This led me to sell my mutual fund and buy ETFs. (Disclosure: I own 20 WisdomTree International Industrial units; 15 WisdomTree International Midcap Dividend units; and, 16 WisdomTree DEFA High Yield units).

You will note that my small ETF holdings are all backed by the same company – WisdomTree Investments. What was the reason I went with WisdomTree instead of ishares or any of the other big names? Dividend weighted indexes!

Dividend Weighted Indexes

In any index, there must be a quantifiable method for allocating weight to each component. In many indexes, such as the S&P500, stocks are weighted according to market capitalization. The bigger the stock valuation (notice I didn’t say company or tangible assets), the larger the weighting. While this method gives you broad diversification, it relies on markets correctly pricing each share. If you believe in the efficient market hypothesis, then you can stop reading right here.

However, if, like me, you believe that the efficient market hypothesis only exists on the pages of text books, then you should be aware that market capitalization has a few problems.

Market Capitalization, Largecaps and Value

The first problem is that weight is assigned to “big” companies ahead of “mid” and “small” cap stocks. If you look at the S&P500, you will see that the top 30 stocks dominate the index, with the top 10 stocks comprising almost 30%. As midcap stocks generally outperform large cap stocks over the long run, a capitalization weighted index is short changing you.

Secondly, and more importantly, market capitalization is not always a good indicator of value. In 2000, some of the highest market capitalization stocks were tech stocks. While not all were bad investments, many of them had poor management, little or no earnings, a concept rather than asset backing and huge price earnings ratios.

If you invested in market capitalization weighted indexes, you were underweight these stocks when they were small caps (i.e. before the big price surge), and then overweight when they had reached stratospheric levels!!! After the stock market crashed, and market capitalization for these stocks fell, the index moved back to underweight. In effect, the index bought at the top and sold at the bottom!

A similar scenario holds true for housing stocks last year and financial stocks currently.

Fundamentally Weighted ETFs – A Viable Alternative

If this seems crazy to you, you may want to consider fundamentally weighted ETFs. In the case of WisdomTree’s dividend indexes, stock weighting is determined by dividend yield. The higher the dividend yield, the larger the index allocation. You are effectively buying the same basket of stocks, but allocating to those stocks with the highest dividend yield. Ideally, you will be overweight stocks when they are “cheap”, with a high yield, and underweight when those same stocks run up in price but the yield does not follow. Each dollar you invest is buying more earning power for your pocket. As a bonus, you will not have an asset allocation to Pets.com unless they are paying a dividend!

So – what is the problem with this strategy?

Firstly, the concept is a new one and not many ETF providers have embraced the allocation as yet. Without a track record of out-performance, there isn’t yet market pressure to drive the creation of fundamentally weighted indexes. In fact, some of the bigger ETF providers have refuted fundamental indexing. Furthermore, with the explosion of ETFs, I suspect many people are either wary of new offerings, or embracing sector specific ETFs to chase performance.

Secondly, you may find yourself overweight some sectors. For example, traditionally financial stocks, such as banks, have higher dividend yields. This can result in a weighting that may be beyond that which you are comfortable with. In the current credit bubble, a heavier allocation to financial stocks may not have a huge downside. However, when the bubble pops and liquidity dries up (and that could be happening right now), there could be big trouble. The recent Bear Sterns CDO problems are just the tip of the iceberg. For that reason, when I invested in ETFs at the end of last year, I allocated about 25% of my investment to WisdomTree’s International Industrial fund. I wanted companies that made “things” to counter the paper assets of financial stocks. You may instead wish to allocate some portion of your portfolio to the consumer discretionary or commodities sectors.

In a similar vein, the international stocks of WisdomTree’s funds can be very Euro- and Australia-centric. Personally, I would like to see a Pacific ex-Australia fund, focusing on northern Asia, including India. Add in Russia, Brazil and Argentina and you could call it an “Emerging Markets” fund. Sadly, the best option of these markets right now appear to be ishares country specific ETFs or actively managed mutual funds.

Lastly, recent performance has not been as hoped, in some cases underperforming capitalization weighted ETFs. When the market is booming and growth stocks are heading for the stars (Apple anyone?), fundamentally weighted indexes may under-perform due to their value vs. growth focus. If you want to allocate to growth stocks, these may not be the funds for you.

Conclusion

Regardless of their flaws, I retain faith that in the long run, especially if volatility returns to the market, fundamentally weighted indexes will outperform their capitalization weighted cousins.

This post is for entertainment purposes only. No part of this post should be construed to constitute investment advice. The author is not an investment professional and assumes no responsibility for any investment activities you undertake. Prior to undertaking any financial decisions, you should contact an investment professional.