SIMON KARABAN - UNDERSTANDING THE INDEX

If you're investing in an ETF you're investing in an index. The ASX200 is an index comprised of the top 200 companies in the Australian market. An ETF that tracks an index likes this is the simplest kind of ETF, and is sometimes known as an "index-hugger".

SIMON KARABAN

Simon is a Senior Vice President at Singapore Exchange where he works with indices, and before that he was at S&P Dow Jones Indices working on Australian indices. Here's a link to all of the current Australian share market indices. It's a useful way of drilling down to find out which part of the market is driving the ASX. But as Simon says, if the market is up or down it's usually due to the big banks and resources stocks that comprise the largest part of the index.

HOW INDICES AND ETFs WORK TOGETHER

"Indices are governed by a set of rules and are very transparent in nature. We ensure that the indices are produced in a very harmonious fashion, which lends themselves to underlie financial products. An ETF issuer, such as a State Street or Blackrock or Van Eck in Australia for example, will actually mimic the movements of the underlying index by allocating weights to the stocks, according to the weights as they're determined by the index themselves. For example, you have an ETF issuer in the Australian market that's tracking the ASX 200, they'll mimic the movements of the ASX 200 by allocating funds that are directly proportional to the weights that are in the index,

There is a commercial relationship between the index administrator, or the index provider, as well as the ETF issuer through an index licensing arrangement where an index provider will charge a index licensing fee to the ETF issuer for the right to use that index as an underlying for the ETF."

THE IMPORTANCE OF LOOKING INTO THE DETAILS OF AN ETF. IT MAY NOT BE WHAT YOU THINK YOU'RE INVESTING IN.

"Investors really need to look past the label of the index and truly understand the underlying components of the index. With the rise of the thematic indexing investors are now piling into different types of ETFs, for example, Robotic ETFs, Biotechnology ETFs and Internet Technologies. Once you start going down this path, you have to ensure that the index provider is actually offering an accurate representation of that thing. 

One of the classic examples that I like to reference is the Blockchain ETF or Blockchain index, and investors have flocked to this index in the form of ETFs primarily because of the label. They see blockchain technologies as an emerging technology that will continue to grow and continue to be part of our lives. But the fact of the matter is that there are very few underlying stocks that specialize in this technology, and what you're finding is that it's really the existing technology companies that are dabbling in blockchain. They're not generating a meaningful amount of their revenue from this technology so you might see a blockchain ETF or a blockchain index that's comprised of companies like Microsoft or NASDAQ or Google and Facebook because in their annual report or somewhere along the lines they've described the fact that they are investing into blockchain technology so investors have to be very careful, once they start dabbling into themes or smart beta indices. 

Another example is concept of what's known as a quality index which aims to choose companies with very sound fundamentals and good rates of profitability. What investors need to be wary of is which financial metrics the index provider is using to find a representation of a quality company. Often you'll find that you're using financial ratios and metrics that are stale. They're also not using the right proxies to be able to address profitability as a factor. So there are a lot of issues in terms of the amount of rigor, or the amount of time and energy that's invested into developing such indices to ensure that they're truly representative of the objective or the label that they've attached to such indices."

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