November 2013 Toroso Investments, LLC
ETFs ● The Business of Indexation Research compiled by Michael Venuto, CIO
Traditional Indexes and Float Adjustment “What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out "You can't buy the averages." It's time the public could. ....there is no greater service [the New York Stock Exchange] could provide than to sponsor such a fund and run it on a nonprofit basis.... Such a fund is much needed, and if the New York Stock Exchange (which, incidentally has considered such a fund) is unwilling to do it, I hope some other institution will.”
The index measurement world has traditionally been dominated by ranking index constituents by market capitalization. The first US listed ETF, SPDR® S&P 500 ETF Trust (SPY), which recently celebrated its 20th anniversary, is a market cap weighted index. The success of SPY and many other ETFs that followed prompted a significant change in weighting methodology, which began in 2006. The new methodology focused on market capitalization but adjusted the weighting for float, which meant companies with substantial insider ownership were allotted lower weights in the index. Consider the following chart: When Insiders Market Float Goes Indexed Products Own
Buy Down Less
Sell Up More
Therefore, products associated with these indexes can handle more assets because the product is not required to buy as many shares of stocks with substantial insider ownership and simplified their ability to fill these purchase orders. In other words, without float adjustment the size of the ETF may hit a ceiling or need to be capped. With these words, Burton Malkiel forever changed the business of security indexation. Although the NYSE did not listen to his advice, John Bogle did and Vanguard launched the first index mutual fund in 1975. Almost 40 years later, indexation represents 10% to 20% of all investing and with the massive, ever-growing pool of ETFs this percentage is likely to grow significantly. Toroso believes this growth creates both opportunities and pitfalls for ETF investors, and the key to success or failure in ETF investing lies in understanding index construction. Simply put, the democratization of the market, as envisioned by Malkiel and Bogle, is nearly complete; however, the transition of indexing from a benchmarking tool to an asset-gathering tool has possibly tarnished many of the benefits indexing provides for the average investor and created significant opportunities for the savvy investor.
The result of this change meant that many of the large index providers realized the scalability and profitability of their asset management/gathering business far outpaced their original revenue streams from licensing a benchmarking tool. Consequently, creating an index became a fast growing adjunct business to developing ETFs and new index providers entered the market to partner with ETF providers. And float adjustment opened the door to potentially higher volatility of the index itself. But the real benefit is the ability to handle significant volume with reduced efforts and thereby create profits for the providers.
Narrower Indexes or Sharp Knives The next wave of indexes targeted sectors, geographic regions, different market caps, growth and value style categories, or simple geometric alternatives like equal
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