S&P Weighs Merits of Various ETF Compositions

As the exchange-traded products industry, just days removed from its 20th anniversary in the U.S., has continued to evolve so has the debate surrounding how ETFs are constructed. Cap-weighting, the methodology that is most pervasive across equity-based funds, is what many investors are most familiar.

That concept is simple as it usually involves ranking an ETF's holdings by market value with the largest company in the fund garnering the biggest weight. For example, Exxon Mobil (NYSE:XOM) is the largest U.S. oil company. Therefore it commands the largest weight in ETFs such as the Energy Select SPDR (NYSE:XLE) and the Vanguard Energy ETF (NYSE:VDE).

The cap-weighting approach has served issuers well, allowing them to offer low-cost broad market and sector funds to investors. Using VDE and XLE as the examples again, those are the two lowest cost energy sector ETFs on the market today.

However, as Apple's (NASDAQ:AAPL) recent tribulations highlighted, there are alternatives to traditional cap-weighting that can also benefit investors.

Some ETF sponsors have taken to introducing equal-weight products. Other issuers sponsor funds that screen for stocks using growth and value factors while some sponsors use dividend growth or yield as ways of building income funds.

In a new research note, S&P Capital IQ examined several ETFs employing various methodologies while noting various approaches do have merit, but "investors and advisors need to understand the structure of the ETF they are considering, regardless of its role in a broader portfolio."

Among the ETFs discussed in the note are two of WisdomTree's (NASDAQ:WETF) most popular products, the WisdomTree Emerging Markets Equity Income Fund (NYSE:DEM) and the WisdomTree Japan Hedged Equity Fund (NYSE:DXJ). DEM, which has seen its assets under management tally, jump to over $5.3 billion from $3 billion in about a year, competes with the popular Vanguard FTSE Emerging Markets ETF (NYSE:VWO) and the iShares MSCI Emerging Markets Index Fund (NYSE:EEM).

S&P Capital IQ notes DEM has an expense ratio of 0.63 percent, well above the 0.2 percent charged by VWO, and that partially leads to S&P's Marketweight rating on DEM. However, DEM's results are hard to argue with. The fund, which tracks an index that is re-weighted annually based on paid dividends, has surged almost 18 percent in the past five years and currently sports a 30-day SEC yield of 3.91 percent, according to WisdomTree data.

S&P has an Overweight rating on DXJ, which has seen its AUM total jump to over $2.6 billion from $516 million in early December. DXJ eschews traditional cap-weighting by focusing on two critical factors: Offering investors a hedge luctuations between the value of the U.S. dollar and the Japanese yen and building a portfolio of companies that derive the bulk of their revenue from outside of Japan.

The latter factor increases DXJ's leverage to a weak yen and the recent results have been stellar. DXJ is up 25 percent in the past 90 days while the cap-weighted iShares MSCI Japan Index Fund (NYSE:EWJ) is up just 9.6 percent.

S&P Capital IQ also has overweight ratings on the PowerShares FTSE RAFI US 1000 Portfolio (NYSE:PRF) and the PowerShares FTSE RAFI Developed Markets ex-U.S. Portfolio (NYSE:PXF). Both ETFs track indexes developed by Research Affiliates and are based on the following fundamental factors: Book value, cash flow, sales and dividends.

That methodology has worked over time. As of the end of 2012, $10,000 in invested in PRF at the end of 2005 would have been worth over $14,300, far outpacing the $13,265 offered by the S&P 500 over the same time, according to PowerShares data.

PRF, which charges 0.39 percent per year, is home to over $1.58 billion in AUM and 991 stocks. Top holdings currently include Bank of America (NYSE:BAC), General Electric (NYSE:GE) and Citigroup (NYSE:C).

Regarding PXF, the fund is up about 10 percent in the past three months. The U.K., Japan and France combine for over 46 percent of the $502.8 million ETF's weight. PXF's 30-day SEC yield is a decent 3.74 percent. Top holdings among the 1,016 featured in the fund include HSBC (NYSE:HBC), BP (NYSE:BP) and Total (NYSE:TOT).

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