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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weighting. All of these have experienced huge success in
asset gathering but have not always offered investors the
desired/expected market exposures.
For example, the sectors are often dominated by a few
companies; market cap indexes overweight the largest
rendering the smaller companies insignificant; the growth
and value indexes have massive overlaps in holdings and
returns; and finally the equal weighted indexes often have
no benefit when compared to similar average market
caps.
Granted these statements are generalizations, and many
sophisticated investors have successfully navigated these
issues to profitable trades. The point is not that these are
bad products because they are designed to raise money;
rather the key is to understand the index methodology so
one can invest in the targeted exposure, and hopefully
enhance the return of the overall portfolio.

The Knives Get Sharper

Two waves of fundamental indexation came next. The
first was dividend or revenue weighting. These ETFs,
from sponsors like WisdomTree and RevenueShares,
started with slow growth, but more recently were able to
capitalize on the low interest rate, yield starved market
environment. These weighting schemes represent clear
value for investors in certain economic cycles but they are
not necessarily buy and hold vehicles, as some marketing
departments would have you believe. For more
information on the right time to hold these types of ETFs
refer to Toroso Commentary September 2013 Small
Caps: What do you own?
PowerShares pioneered the second part of fundamental
indexation through their RAFI methodology, which quickly
found competition from First Trust and their AlphaDex
series. Both of these methods focus on a number of
fundamentals like Cash Flow, Book Value and Sales.
In sideways or non-directional markets these ETFs have
produced superior risk adjusted returns since these are
the markets when fundamentals matter. During strong bull
and/or bear markets these ETFs have provided much less
value, possibly due to expenses which can be two to five
times the cost of traditional beta ETFs, and secondarily
the delinking of the underlying fundamentals in a
momentum driven market.

The Knives Lose Precision

The obvious next step was to move into active ETFs and
leave the index behind. Without having an index to follow,
the provider is given wider latitude in determining which
securities will make up the basket for the ETF. Selling
these ETFs has proven much more difficult than most
market professionals expected. Passive ETFs have been

primarily viewed as tools to get precise exposures;

whereas active mutual funds have been sold on incentives
and performance, even though every piece of financial
marketing material includes a disclosure warning that
past performance is not an indication of future results.
Active ETFs, like passive ETFs, have no way to provide
incentives so they rely solely on performance and a good
story or brand. Unfortunately, ETFs require volume to
succeed as well; most investors will not purchase an ETF
that trades only a few thousand shares a day no matter
how superior the relative performance. So despite a few
notable exceptions from companies like PIMCO, active
ETFs have yet to truly succeed as asset gathering
vehicles or investment tools for the masses. We believe it
will take some time for active ETFs to gain a significant
foothold in the space.

The Experts Only Category

Now lets discuss path dependent ETFs, which includes
leveraged, inverse, futures based commodities and/or
volatility. We use the term path dependent because these
are almost always guaranteed to be poor long-term
investments.
For example, the leveraged ETF sponsor ProShares has
raised through net creations close to $80 billion in assets
yet currently oversees about $26 billion in ETFs. This
comes from the nature of a daily reset index in a volatile
environment. Simply put, the structure of these indexes
causes compounding to work against the investor in nondirectional environments; so in theory, as well as practice,
one could own equal positions in the two times long ETF
and two times short ETF and still lose a significant
percentage of money.
The same phenomenon can occur in futures based
commodity ETFs or the Chicago Board Options Exchange
Market Volatility Index (VIX) focused ETFs but for different
reasons. These structures often experience negative
returns due to a concept known as contango, which is the
difference between the cost of immediate exposure and
future exposure. What this cost can be compared to is the
storage and delivery cost of raw materials, which varies
but can be quite expensive. For example, when utilizing
ETFs to gain exposure to the VIX there is no physical
delivery possible, so the contango is often very high.
iPath S&P 500 VIX Short Term Futures Exchange-traded
Note (VXX) is by far the largest product in this space and
tracks the VIX short-term futures index. Since its inception
in 2008 it has annualized at negative 59% return. But
when used as a trading strategy, there are possible gains
to be realized. Toroso believes investors should carefully
employ these ETFs as either short-term trades or longerterm shorts.

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The Current Frontier of ETFs

Perhaps the most interesting form of an index as an ETF
focuses on business characteristics. No ETF sponsor has
focused on this methodology exclusively but a selected
few have issued some ETFs. These ETFs strive to
identify a characteristic of a business that should perform
well in certain economic cycles. This includes companies
that are buying back shares, companies with high relative
insider buying, spin-offs, companies that have conviction
buying from hedge funds and companies that exhibit high
barriers to entry or long product life-cycles. The Appendix
below provides the list of ETFs that, to our knowledge,
make up this category.
These indexes allow investors to target the characteristics
that active mutual fund and hedge fund managers look for

in an equity but do so in a more diversified way. They also

provide access to characteristics that may provide future
growth or value exposure, rather than focusing on
companies that have traditionally fit those categories.
Using these ETFs in a portfolio may provide unique
benefits typically missed in strategies built on the asset
classes of modern portfolio theory.

In Conclusion
Toroso believes ETF investing is not about filling points
along the efficient frontier, but about solving for objectives
within a portfolio. That is why we may employ any of
these index methodologies at a certain time in the
economic cycle. We believe in looking for the ETF with the
best exposure that meets our clients investment objective.

Appendix
Business Characteristic ETFs

Ticker

AUM
(mil)

Expense Ratio

# of Holdings

Inception Date

AlphaClone Alternative Alpha ETF

ALFA

29

0.95

83

May 2012

Forensic Accounting ETF

FLAG

0.85

399

Jan 2013

Guggenheim Spin-Off ETF

CSD

557

0.65

24

Dec 2006

Global X Guru Index ETF

GURU

259

0.75

55

Jun 2012

Market Vectors Wide Moat ETF

MOAT

494

0.49

20

Apr 2012

Guggenheim Insider Sentiment ETF

NFO

184

0.65

101

Sep 2006

PKW

2,117

0.70

198

Dec 2006

PowerShares Buyback Achievers

TM

ETF

Disclaimer -- This commentary is distributed for informational and educational purposes only and is not intended to constitute legal, tax, accounting or
investment advice. Nothing in this commentary constitutes an offer to sell or a solicitation of an offer to buy any security or service and any securities
discussed are presented for illustration purposes only. It should not be assumed that any securities discussed herein were or will prove to be profitable,
or that investment recommendations made by Toroso Investments, LLC will be profitable or will equal the investment performance of any securities
discussed. Furthermore, investments or strategies discussed may not be suitable for all investors and nothing herein should be considered a
recommendation to purchase or sell any particular security. Investors should make their own investment decisions based on their specific investment
objectives and financial circumstances and are encouraged to seek professional advice before making any decisions. While Toroso Investments, LLC
has gathered the information presented from sources that it believes to be reliable, Toroso cannot guarantee the accuracy or completeness of the
information presented and the information presented should not be relied upon as such. Any opinions expressed in this commentary are Torosos
current opinions and do not reflect the opinions of any affiliates. Furthermore, all opinions are current only as of the time made and are subject to
change without notice. Toroso does not have any obligation to provide revised opinions in the event of changed circumstances. All investment
strategies and investments involve risk of loss and nothing within this commentary should be construed as a guarantee of any specific outcome or profit.
Securities discussed in this commentary, including the ETFs presented in the Appendix, were selected for presentation because they serve as relevant
examples of the respective points being made throughout the commentary. Some, but not all, of the securities presented are currently or were
previously held in advisory client accounts of Toroso and the securities presented do not represent all of the securities previously or currently purchased,
sold or recommended to Torosos advisory clients. Upon request, Toroso will furnish a list of all recommendations made by Toroso within the
immediately preceding period of one year.

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