Vanguard: Index Development Rises With ETF Product Growth

according to Joined at the hip: ETF and index development. As of March 31, 2012, more than $1.2 trillion was invested in about 1,400 U.S.-listed ETFs (source: Strategic Insight’s Simfund) and currently, U.S.-listed ETFs seek to track more than 1,000 different indexes (source: Vanguard, based on Bloomberg data). Vanguard researchers find that more than half of these discrete indexes had been in existence for less than six months before the launch of an ETF that seeks to track it. In addition, more than half of the indexes use back-tested performance data (i.e., data based on retroactively applying the index methodology to historical data) in lieu of or in addition to live performance data (i.e., real-time performance data after index-live date).

The new paper demonstrates that back-tested performance data may not be a reliable indicator of how an index will perform after it is launched. Using data for 370 indexes that had at least six months of back-filled data and six months of live data in the period from 2000 through 2011, Vanguard researchers analyzed the performance of these indexes both in the back-filled data period and in live data. They found that while 87% of the indexes outperformed the broad U.S. stock market for the time in which back-tested data were used, only 51% did so after the index was launched.

“When historical index performance is hypothetical, the notion that past performance may not indicate future results is especially true,” said Joel Dickson, one of the study’s authors and a principal in Vanguard’s Investment Strategy Group.    

While securities regulations prohibit the use of back-tested performance for most U.S. mutual fund and ETF providers, index providers are not held to the same rules. Index providers, therefore, have used back-filled data and offered it through public means, either on their own websites or via third-party data providers, which often makes it difficult for investors to discern which data are hypothetical and which are live.

Many investors view an index as an objective market-capitalized representation of a market or market segment, but alternative index-weighting methodologies have exploded in the last decade. Vanguard researchers found that 20 different weighting methods and 27 different selection criteria exist for indexes that seek to be tracked by ETFs. According to IndexUniverse, the percentage of ETF products based on alternative weighting approaches jumped from 5% in 2000 to almost 50% in 2011.

The analysis shows that recent index creation may not only be about providing investable benchmarks for market segments; it may be about providing ETF sponsors a way to market and promote new products with ready-made indexes that might jump-start the acceptance and viability of new offerings.

Vanguard is the third largest U.S. ETF provider by assets under management and leads the industry in year-to-date cash flow of $28.8 billion into U.S.-based ETFs through the first half of the year.