Look under the bonnet before buying the car

WITH so many exchange-traded funds (ETF) on offer, it’s hard to know what difference it makes which one you choose. But one way to narrow it down is to examine the underlying benchmark the fund is tracking. In fact, it makes very little sense to choose an ETF without at least glancing over the structure of the benchmark it uses: alongside the fee structure, tracking error and counterparty risk, the quality of the index should be top of the list for scrutiny.

This is all the more important when it comes to investing in an emerging markets ETF, where there can be greater variation in the construction of the indices because of the huge variation in the structure of the underlying markets they are trying to capture. That is why this week’s page provides a breakdown of several major emerging market (EM) benchmarks.

One of the major determinants of a benchmark’s structure is what kind of weighting it uses. The norm (two of the four examples displayed) is that the benchmark is weighted purely by market capitalisation (subject to certain requirements), but this skews the index heavily in favour of countries with highly liquid and developed equity markets and away from those that actually account for a larger proportion of EM wealth but have more restricted or limited stock offerings. Fundamentals weighting is another method, explained in the box below (FTSE?RAFI?emerging index).

Other factors to take into account include whether or not the index has a minimum market cap size requirement and what kind of liquidity rules are applied. These can vary significantly, with some index-providers, such as MSCI, monitoring a firm’s liquidity both in the short- (one month) and long-term (one year). MSCI’s analysts look at a company’s trade value ratio – how much of its stock is traded during the course of a year – as well as the frequency of trades in order to decide whether to include it in an index.

Whatever your choice, it makes sense to check out the engine before loading any valuable possessions into the car.