More ETF Magic

About the only joyous thing about Christmas is that there is a marked slowdown in the amount of junk  mail that hits my inbox. And to be honest I do miss the emails telling me that people have the ideal job for or that Svetlana from Kokshetau in Kazakhstan is desperate to send me pictures of her recently shorn yak. Paradoxically I have not seen a slowdown in the number of emails extolling the virtues; nay magic of index ETF’s. This got me thinking about the nature of indices and their construction. In simplest terms an index is simply an aggregation of stocks design to represent a sector of the market. However, stocks are not simply lumped into a group and passed off as an index, an index can be either price weighted such as the Dow or market value weighted index such as the S&P500.  With the Dow the weighting of each component is a function of its price whereas with the S&P500 components are weighted according to total value of their outstanding shares. Each method of construction results in a different end product.

Because we have two mechanisms of solving the same problem we can compare and contrast what each solution looks like when plotted against one another. This might seem to be a somewhat academic problem and in many ways it is is except when you consider that when being told to buy an international ETF investors are directed towards SPY which is a representation of the S&P500 –  a market weighted index. You might think so what but remember this is not the only way to measure an index and that the folks who create ETFs are nothing if not inventive. As such there is a price weighted version of the S&P500  known as the Guggenheim S&P 500® Equal Weight ETF or RSP

It is therefore easy to compare the performance of these two instruments –

For the period being considered it appears as if the equal weighted version has given the market weighted ETF a bit of a belting. This raises the question as to why do dislocations occur between the performance of two indices constructed using different methodologies and the blindingly obvious answer is that it is the different methodologies account for the different performance. Granted they hold the same stocks but they hold them in different ratios. For example SPY’s largest holding is Apple which makes up 3.12% of its portfolio whereas its holding in RSP is capped at 0.21%. This means that when Apple does well SPY will do well but when it does poorly it will drag the performance down. Equal weighted indices are to some extent insulated against the travails of a single stock.

The existence of instruments such as RSP introduce a layer of complexity for ETF traders since they offer a variation on the theme of index investing that may or may not suit them. Unfortunately, for those who pump magic index ETF systems the world is a little more nuanced than they think it is.