Originally from our sister publication, Advisor.ca.
The tremendous growth of ETFs over the past decade has coincided with a surge in the development of many new indices.
While more products mean more options, most of these indices lack sufficient performance history, says Vanguard. That’s because they’re largely based on narrow segments and alternative weighting schemes.
Also, more than half include back-filled performance data from before the indices were launched, making it hard for investors to discern what data is real versus hypothetical, the company adds.
“More than half of ETFs are launched with an index that has been in existence for less than six months,” says its new paper, Joined at the hip: ETF and index development. “We also find ETFs are most likely to be created with indexes that have performed well relative to the broad U.S. stock market before the inception date, but that such performance on average does not persist.”
And, in fact, the use of back-filled performance data for promotional purposes is prohibited by FINRA. But, since most index providers aren’t affiliated with a fund or the ETFs tracking its index, they aren’t subject to these rules, says the paper.
Vanguard also suggests companies are creating indices to promote new products rather than provide benchmarks for different asset class segments, so investors must be cautious when choosing such products.
“Many investors have traditionally thought of an index as an unbiased, objective representation of a market or market segment,” it says. “The concept of an index as a basket of traditional, market-capitalization-weighted securities has been expanded, and is now done to help develop and differentiate new products.”
The paper says more than $1.2 trillion was invested in approximately 1,400 U.S.-listed ETFs as of March 31, 2012. The funds track more than 1,000 different indices, which represent a vast array of investment strategies.