Funds tracking alternative indices are still in the minority, and Justice says it's going to take a while to educate investors about the nuances of these investments, especially how they impact a portfolio. In particular, investors should be aware of the potential for greater transaction costs as a result of the rebalancing alternative indices do. This also increases the potential for capital gains taxes if certain securities are sold at a profit after rebalancing. "You're going to have more transaction drag," Justice says. "You're going to pay more taxes within the strategy. Those costs are going to impact returns over longer periods of time."
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Graves also says investors should take note of the sector exposure a particular indexing method produces. For instance, as of late February, consumer discretionary exposure accounted for about 11 percent of total assets for the market-cap weighted S&P 500, whereas its equal-weighted counterpart had a much heavier exposure of about 16 percent. "Look not only at what kind of individual stocks are in an ETF, but what is the concentration or weighting based on sector," he says. "You've got to think about what you're getting when you buy an equal-weighted S&P 500 versus a market cap-weighted."
Above all, investors should understand what they're buying, Justice says. "When you're looking at ETFs, you've seen a lot of innovation over the last 10 years because you have to have an index in order to make an ETF," he says. "The concept of an index has really changed. Now you've created so many indexes it gets to the point these aren't things to measure the market anymore."
Twitter: @mmhandley
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