Mar 22, 2010
A strong performing ETF this year is the Rydex Small-Cap Pure Value ETF. Rydex came out with ETFs that track the 'S&P Pure Indexes' a few years ago. What are these?
Index providers create growth and value indices out of their core index. For example, Russell takes the Russell 2000 and divides it into 2 groups: growth and value. They have developed rules for how to do this, such as price to book value and 'expected analyst earnings growth.' For some companies -- it is obvious which index it qualifies for: such as a company with a high price/book and high expected growth rate will obviously be a member of the growth index. But there are many companies that sit more in the middle, companies where Russells construction rules are in a bit a conflict. Russell in this case takes the weighting and divides it into part growth and part value, such that if a given company has a 0.40% weight in the Russell 2000, it might have a 0.31% weight in the Russell 2000 growth and the remaining 0.09% goes into the Russell value index.
The S&P 'Pure Indexes' don't do this -- for these indexes, S&P uses only the companies that qualify 100% as value or growth. This is not magic, it is just a different method of index construction backed by a major index provider (S&P). ETF analysts should understand who the index provider is for any given ETF and their reputation when reviewing ETFs. In this case, S&P is a major index provider and not a provider created out of thin air simply in an attempt to lay 3rd party credibility to financial products (ETFs).
Back to the point, what is the net effect of this different construction methodology?
The Rydex funds become more concentrated with less securities in the index. This concentration makes them more volatile than others. You can't say its better or worse, its just a different method. I ran the Rydex Small Cap Pure Value ETF in the backtest tab of ETFreplay ( http://www.etfreplay.com/combine.aspx ) just to look at the characteristics.
Given the very large shift in overall market volatilties we have seen, I settled upon looking at volatility since June 30, 2009. Why? Because this is when the financial sector (XLF/KBE) seemed to normalize -- overall market volatility has come in a great deal since then and if you run charts back before that date, the net volatility number will be quite skewed.