Not all tracking is equal, and it can pay to know which your ETP uses

ONE of the biggest attractions of exchange-traded funds (ETFs) is that they track indices such as the FTSE 100, giving investors exposure to the performance of these benchmarks without requiring them to hold actual shares.

In order to replicate the performance of the underlying index as closely as possible, the fund has to include exposure to all of its constituents. The typical way in which this is achieved is by weighting the components according to their market capitalisation. For example, if Barclays’ market cap was 8 per cent of the total for the FTSE 100, then the ETF would also have 8 per cent exposure to the bank.

However, there is a flaw with such a methodology, which can create inefficiencies. If the ETF uses an underlying index weighted by market capitalisation, then the fund will tend to be overweight in expensive companies and underweight in cheap firms. This is inherent in the market cap calculation – number of shares issued multiplied by the price.

“Investors are always taught to buy low and sell high. ETFs of market cap-weighted indices inherently do the opposite,” says Invesco Perpetual’s head of listed fund sales Tim Mitchell. “You would be putting less and less money into cheaper and cheaper stocks.” This gives investors a lower return.

Invesco Perpetual’s ETFs division Powershares has tried to address this problem by using a different method of weighting indices, known as fundamental weighting. This ignores the share price of a firm, which means that the index does not reflect the noise of the market. Studies have found that fundamental-weighted indices outperformed the cap-weighted benchmark by about 2 per cent a year.

Instead, Powershares uses the FTSE RAFI indices as the underlying benchmarks for a number of its major ETFs. These are weighted using fundamental criteria: an average of a company’s sales, cash flow and dividends over the past five years and the latest book value – the total value of the firm’s assets that shareholders would receive if the company were liquidated.

These indices should give a weighted exposure based on how good each constituent is relative to its peers. This should then be reflected in the performance of the ETF that tracks the index. In general, being overweight on stocks with good fundamentals but which have seen a drop in their share price should generate higher-than-average returns for the index.

For example, Barclays saw its share price fall in 2009 along with the wider market and the banking sector in particular. But relative to its peers, the bank is regarded as having relatively strong fundamentals. A fundamental-weighted index would have accounted for this by increasing the stock’s weighting whereas a cap-weighted index would have reduced its importance.

This may seem complex but investors do not need to worry about which particular stocks are overweighted and which are underweight. The index provider will rebalance the index accordingly – the FTSE RAFI does this annually in March.

However, fundamental weighting is not always seen as a perfect solution. A frequent criticism is that investors will suffer from higher costs because the underlying index needs to be regularly rebalanced and the ETF exposure updated accordingly. While this might not be reflected in higher fees, transaction costs will be passed on in lower performance.

But it is worth noting that the plain vanilla FTSE ETF is rebalanced every quarter, while the fundamental-weighted index is only rebalanced annually so investors should not be too concerned. It is clear that fundamental weighting works most effectively with equity indices – for one, it is more straightforward to assess the fundamental value of a company than it is, say, of a bond.

Fundamental-weighted indices are not yet mainstream but this is likely to change as ETFs become more popular and investors more savvy.