Exchange-traded funds are benchmarked to an expanding universe of indexes. Those indexes range from traditional passive benchmarks that use capitalization weighting to sophisticated quantitative strategies and alternative weighting methods. This article links index strategies to ETFs expenses. There is clear evidence that ETFs following more sophisticated index strategies charge higher fees than ETFs following passive market benchmarks. I use a new database at ETFguide.com to classify ETFs by index strategy and create a unique pricing model for ETFs based on index strategy. The model enables investors to compare the expenses of ETFs with like strategies, and guide ETF providers toward a sound pricing model.

Index Classification Terminology

Indexes can be classified by basic purpose and specific strategy. There are two basic types of indexes. A market index is a traditional “plain vanilla” measure of market value that uses passive security selection and weights securities based on market capitalization. To the contrary, a strategy index is a technique for investing in the markets rather than a measurement of market value. In a sense, market indexes track market “Beta,” and strategy indexes attempt to create some type of “Alpha,” either in financial terms or in expressive terms such as with socially responsible indexes.

Market indexes are designed to measure the performance of financial markets. They are characterized by passive security selection and capitalization weighting. Security selection can include the entire universe of securities, a sampling of securities or one item such as the price of gold. Capitalization weighting can be in the form of full float, free float, liquidity or production weighting. The primary purpose of market indexes is tied to measurement, not performance. They provide a measurement of market risk and return, which can be summed up as beta.

Strategy indexes are investment strategies. They are custom-made to seek “Alpha” in the marketplace in whichever way their creators define alpha. ETF companies that use strategy indexes often imply that their products offer something better than ETFs that follow market indexes. WisdomTree promotes their fundamental strategy indexes as “Built differently, with the goal of higher returns with less risk.” PowerShares claims their ETFs offer “exceptional asset management tools” through the replication of “enhanced indexes.”

Index strategy classification goes to a different level with the use of the Index Strategy Box categorization system. ETFs are separated into different categories based on their security selection and security weighting techniques. There are three broad selection strategies: Passive, Screened and Quantitative; and three broad weighting strategies: Capitalization, Fundamental and Fixed. The three security selection methods and three security weighting strategies form a matrix. Figure 1 shows the nine-box tic-tac-toe design of Index Strategy Boxes.

Analysis Of ETFs And Fees By Index Strategy

The classification of ETFs by Index Strategy Boxes is available at ETFguide.com. The database included data on all ETFs, exchange-traded notes (ETNs), HOLDRS, BLDRS and other exchange-traded portfolios. For this article, I screened the database for all U.S. long-only equity ETFs. The list included funds that follow broad market indexes, market size and style indexes, industry sectors indexes and thematic indexes. No inverse or leveraged funds were included. There were 304 funds in the database that matched the criteria.

I sorted the 304 funds by the Index Strategy Box information and calculated the number of funds across each of the three broad security selection methods; each of the three broad weighting methods is shown in Figure 2. I also showed the distribution of the funds within the nine Index Strategy Boxes (shaded section).

Figure 2 maps the universe of U.S. equity ETFs by index strategy. The row labeled “Passive” has 160 total ETFs. Those funds follow indexes that use a passive security selection strategy. Of the 160 funds, the 124 in the green block also follow a “Capitalization” weighting method. These are the traditional market index funds. The other 36 ETFs in the passive selection row follow alternative weighting strategies. Of those, 14 funds weight stocks using a fundamental method and 22 use a fixed-weight method. These 36 funds follow strategy indexes. The strategy is alternative weighting.

ETFs that select securities using either basic stock screens or advanced quantitative methods are highlighted in different rows. Those rows were also divided into the three weighting methods. When complete, all 304 ETFs were in one of the nine boxes.

Index Strategies And ETF Fees

After categorizing all 304 ETFs by their underlying index security selection and security weighting methods, I calculated the average fee for the ETFs in each security selection strategy and security weighting strategy. Then I calculated the average fee for each of the nine Index Strategy Boxes. The results of that analysis are in Figure 3.





Figure 3 shows that U.S. equity ETFs that follow market indexes (green shade) charge on average 0.30 percent in annual fees. Thus, it can be said that basic beta exposure to various segments of the U.S. equity markets cost 0.30 percent on average. That may seem high at first observation, but recall that the 124 funds in the box include many types of market index ETFs. In addition to broad market indexes, there are many subsets, including industry sector funds; growth and value funds; and large-, mid- and small-cap funds. The fees charged for sector and style slices of a broad market index tend to be higher than the fee for a broad market index ETF. For example, iShares Dow Jones U.S. Technology Sector Index Fund (NYSE Arca: IYW) has a fee of 0.48 percent, while the iShares Dow Jones Total Market Index ETF (NYSE Arca: IYY) has a fee of only 0.20 percent.

At 0.30 percent, basic “Beta” exposure through ETF investing is relatively inexpensive, while the quest for “Alpha” through funds that follow strategy indexes is more expensive. As security selection methods and security weighting techniques become more complex, the fees charged by ETFs to manage portfolios to those indexes go up. There is a direct correlation between the complexity of the index and the cost of ETF management.

ETF Fee-Pricing Model Based On Index Strategy

I created an ETF pricing model based on the information from the Index Strategy Box fee data. The purpose of the model is to benchmark ETF fees to the complexity of each underlying index strategy. Investors have been conditioned to pay higher fees for ETFs that follow alpha-seeking strategy indexes. However, until now there has been no model for relating different indexing strategies to ETF fees. The model is a guide to average strategy pricing. No assumptions are made as to whether any particular index strategy is worth the average fee charged by ETF companies to follow that strategy.

There are two uses for an ETF pricing model based on index strategy. First, investors can compare the fees of ETFs using like indexing strategies. Second, ETF companies can use the data to price new ETFs in line with the competition, and possibly reprice existing ETFs to align them with the average.

Some adjustments needed to be made to the raw fee data to smooth out inconsistencies. Those issues existed mainly from the pricing of security weighting methods; for instance, an adjustment for ETFs following fixed weight methods because of the large number of higher-cost quantitative funds that use a fixed security weighting method. Also, certain index methods commanded higher-than-normal fees even though their strategy is similar to indexes by other vendors. For example, ETFs following fundamentally weighted RAFI indexes were considerably more expensive than ETFs following other fundamentally weighted indexes such as WisdomTree products. Once these adjustments are made, it was possible to create the Index Strategy Box pricing template in Figure 4.

Figure 4 represents additional fees added to the average fee for beta-seeking ETFs in a particular category. Recall that beta-seeking indexes use passive security selection and capitalization weighting. As an example, the iShares S&P 100 Index (AMEX: OEF) charges a fee of 0.20 percent. If an ETF were created that tracked an equal-weighted S&P 100 Index, a reasonable fee would be 0.35 percent. That is the sum of a 0.20 percent market index strategy plus an extra 0.15 percent fixed-weight strategy fee.

I checked the pricing against different index styles to test for consistency of Index Strategy Boxes fees across nonoverlapping sets of data. The three styles I tested were 1) broad market and large-cap ETFs, 2) mid-cap and small-cap ETFs, and 3) industry sector indexes. The fees charged by ETFs in the three different data sets were remarkably consistent with the pricing template in Figure 4.

An Example Of Fee Pricing With Index Strategy Boxes

The Index Strategy Box fee pricing template is a valuable tool that can be used by investors, advisors and ETF providers. The following is an example of how this pricing model can be applied.

I analyzed the fees in the U.S. broad market and large-cap sectors from the ETFguide.com database. The average ETF fee for beta exposure in this category is 0.20 percent. Once the cost of beta was known, I applied the Index Strategy Box pricing template to the 0.20 percent fee. The results are illustrated in Figure 5.

Investors and advisors can refer to the data in Figure 5 to determine fair fees for each ETF that follows a particular index strategy. For example, assume an advisor is considering the purchase of a U.S. large-cap growth ETF. The cost for one ETF under consideration is 0.35 percent, while the cost for another is 0.60 percent. Which ETF is more or less overpriced than the other?

The answer is that it depends on the underlying index strategy of each fund. If the 0.35 percent ETF is a passively selected and capitalization-weighted “Beta” fund, and the 0.60% ETF follows an alpha-seeking index that uses a quantitatively driven index and weights stocks using fixed weights, then based on index strategy alone, the 0.60 percent fund is a better value than the 0.35 percent fund.



I am NOT suggesting that investors should buy the 0.60 percent quantitative ETF. Rather, I am suggesting that the 0.35 percent beta ETF is overpriced.

Summary

There is a clear link between the complexity of index strategy and the fees ETF companies charge for products. It is important for investors and advisors to understand this relationship when analyzing competing products.

The Index Strategy Box Pricing Template for ETFs is one tool that can be used to compare the pricing of any category of funds. The methodology should assist investors with ETF comparisons and guide product providers to create a more uniform pricing model.