When deciding on which Exchange Traded Fund to buy, there are different methodologies from which to choose. Carl wrote about the differences in construction in his post called Cap-Weighted vs. Equal Weighted. As he mentioned, there can be important biases built in to the products which could provide benefits or downfalls in different markets. For instance, the equal weighting methodology lowers the market capitalization of the index and may be more beneficial in a bull market. However, it is important to realize that each fund can dramatically drift from the stated construction rules and performance could be affected.
We owned an ETF called the First Trust NYSE Arca Biotechnology ETF (FBT) which is designed to replicate the price and yield of that exact index. The index is an equal weighted, 20 member biotechnology index which includes well known companies such as Genzyme and Amgen. But it was through a lesser known, small cap company called Human Genome Sciences (HGSI) where we experienced the dramatic drift (beneficially) in construction. The company had successful Phase 3 trials for their new Lupus drug called Benlysta and the stock exploded from $3.30 a share on July 17th to $18.80 today.
The explosion in the stock price took the equal weighted index and propelled HGSI to a 22% weight from 5% (20 stocks equal weighted). And the fund had stated in its prospectus that it would only rebalance the stocks every quarter back to a balanced state. With a 22% weight HGSI would dominate the performance of the ETF and it would no longer provide us with the equal weight methodology for which we originally invested. We decided it would be prudent to sell the fund and capture the gains provided by HGSI, and find a better alternative. With the explosion of ETFs over the last few years there are several options for most sectors and we will continue to evaluate them to ensure that we are invested wisely.
