07) Exchange-Traded Funds: Equity ETFs

by · October 16, 2010

Equities are a principal asset class for investment portfolios, and thus, it is imperative to know the different available options to have a diversified portfolio based around equity exchange-traded funds.

Total Market and Broad-Based ETFs

This is also called Total Market ETFs. This is designed to cover the entire US equity market. A long-term investor can pratically cover equities with a single ETF. Broad-based ETFs have a low expense ratio, narrow bid-ask spread, and lower volatility compared to a more focused ETF.

Examples are:

  • iShares Dow Jones US Inded Fund (IYY)
  • SPDR Dow Jones Total Market ETF (TMW)

Global Coverage

This kind of ETF covers most stock exchanges in developed and emerging markets. The all-world ETF represents the whole world including the US, while all-world ex-US excludes the US. An ETF that provides global coverage is a good choice to add to a portfolio that is already full on US equities.

Examples are:

  • SPDR S&P World ex-US ETF (GWL)
  • iShares MSCI ACWI Index Fund (ACWI)

Developed Markets versus Emerging Markets

Emerging markets stocks have characteristics that are not similar to developed markets. Investors usually consider the following entities as distinct asset classes:

  • Developed markets excluding US, e.g. MSCI EAFE Index Fund (EFA)
  • Emerging markets, e.g. iShares MSCI Emerging Markets Index Fund (EEM)
  • Equities

Sector ETFs

This ETF allows investing on several distinct industrial sectors. It can be used to build a portfolio or make specific sector investments. One advantage of sector ETFs is portfolio rebalancing. That is, selling sectors that have outperformed and purchasing those that have underperformed. This minimizes sectors that are over-valued and can improve the performance of portfolios.

A disadvantage of sector ETFs is that it is more expensive. Compared to broad-based ETFs, the trading costs will be higher. It is also recommended not to mix the different sector families.

Examples of families of sector ETFs are:

  • State Street Global Advisors S&P Sector ETFs
  • Barclays iShares Dow Jones Sector ETFs

Market Capitalization ETFs

For most experts, stocks are generally divided by their market capitalization: large cap stocks, mid cap stocks and small cap stocks. One way of diversifying a portfolio is by getting one of each. A strategy like this commands better customization compared to one broad-based ETF.

Examples are:

  • iShares Russell 1000 Index Fund  (IWB)
  • SPDR Dow Jones Small Cap ETF (DSC)
  • SPDR Dow Jones Large Cap ETF (ELR)

Again, it is advised not to mix the family of ETFs.

Growth & Value ETFs List

ETF investors have the option to acquire either ETFs with value stocks or those with growth stocks. Typically, value stocks are regarded as more inexpensive – low price to book value, low P/E ratio, high-dividend yield. Growth stocks, otherwise, are the more expensive considering that they are expected to have higher earnings, book value and dividends in the future.

Examples are:

  • iShares S&P 500 Growth Index Fund (IVW)
  • iShares Russell 3000 Value Index Fund (IWW)

Leveraged ETFs

Leverage ETFs use options and futures instead of getting stocks from the index. It provides a better exposure to broad markets but comes with higher volatility. With a higher leverage, the extra cash is used to buy bonds to cover expenses and pay dividends to the investors. Typically, this has a higher expense ratio compared to standard index ETFs.

ETFs of this kind are used by investors to increase exposure to a particular index without having to resort to borrowing money. It is also used to play in short-term market movements.

Examples are:

  • ProShares Ultra S&P500 (SSO)
  • ProShares Ultra MidCap400 (MVV)

Quantitative ETFs

Quantitative ETFs use enhanced indexing to identify a subset of stocks from an index that are expected to outperform. Aside from this, it uses predefined rules to rank stocks through fundamental and technical factors. Usually, hi-ranking stocks from the fund universe are picked to form an index. Stocks rankings are done quarterly to reflect changes in ranks.

A type of quantitative indexing is the Fundamentally Weighted Index which uses factors like revenue and cash flow to rank the stocks instead of market capitalization.

It is important to note that creating a diverse portfolio using quantitative ETF is difficult since the investor does not know the stocks it holds. This also has a high stock turnover, higher trading costs and higher tax rates.

Examples are:

  • First Trust Large Cap Core AlphaDEX ETF (FEX)
  • PowerShares Dynamic Market Portfolio (PWC)