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Your ETF Owns Too Little Amazon, and Other Index Quirks

State Street Global Advisors threw a 20th anniversary party this week for its pioneering SPDR S&P 500 Trust (SPY), which ushered in the exchange-traded-fund era.

And rightly so: The flagship “Spyder” ETF is among the most successful investment products ever, rising to $123 billion in assets, trading 144 million shares a day and anchoring an industry that has gone from zero to $1.4 trillion in two decades.

ETFs are the rare instrument that work equally well both for eye-blink day traders and buy-forever tortoise investors by combining near-frictionless liquidity, fidelity to their underlying indexes, low expenses and tax advantages.

And yet the popularity and financial heft of ETFs have created some distortions related to the way indexes are fashioned to accommodate the funds.

The "free-float" formula

Standard & Poor’s several years ago began assigning companies weights in the S&P 500 index according to their “free float” market value, counting only the shares that trade freely and excluding those held closely by large insider owners. The only reason for such a policy, shared by other index providers, is to ensure that ETFs and other index funds can buy and sell the stock they need to trade easily.

For most companies, the difference is trivial. But for those with founders or other big anchor shareholders still involved, the differences can be dramatic. It just so happens that big companies with large founder stakes tend to outperform the market over time. These are exactly the stocks that ETFs own less of, relative to the size of the companies.

For instance, the six S&P 500 stocks with the greatest gap between their free-float market value and their larger, total market capitalization are now Wal-Mart Stores Inc. (WMT), Amazon.com Inc. (AMZN), Berkshire Hathaway Inc. (BRK-A, BRK-B), Google Inc. (GOOG), Visa Inc. (V) and Oracle Corp. (ORCL). Founding executives or families (or, in Visa’s case, banks that formed the card processor) hold large blocks in these companies, and so ETF owners hold smaller positions in these names than their corporate scale alone would dictate.

The average annualized total return of these six stocks in the past five years was 13.7%, compared to 4.3% for the S&P 500 itself. Only Berkshire trailed the index over that period. (Visa’s return is calculated from its IPO date in March 2008.)

This might be considered a statistical fluke, except that, over time, big companies run by “owner-operators” have tended to do better than the broad market. Asset-management firm Horizon Kinetics tracks this apparent advantage in its Horizon Kinetics ISE Wealth Index, which has beaten the S&P 500 by an impressive 2.7 percentage points annualized in the 20 years ended Dec. 31. The Virtus Wealth Masters mutual fund (VWMAX) tracks this index.

Such structural inefficiencies can be more pronounced when it comes to narrower slices of the market. For instance, 10 large real estate investment trusts held most heavily by the popular vehicles such as Vanguard REIT Index ETF (VNQ) have dividend yields averaging around 3.2%. A selection of REITs that are at or near $1 billion in market value yet are not as well represented in the index ETFs have more attractive valuations and yield more than 4.5%. This represents a "liquidity premium" driven by all that ETF money. A small investor who doesn't need to trade huge volumes can exploit this by owning the smaller, cheaper names.

Investors can also take advantage of the mechanical turnover in ETF-driving indexes. As Ryan Detrick of Schaeffer’s Investment Research noted in a recent Breakout video interview, stocks that are ejected from the Nasdaq 100 index have tended to do very well in the year after they’re discarded by this benchmark, which is tracked by the popular PowerShares QQQ fund (QQQ).

None of these quirks undermine the utility of ETFs for providing inexpensive and convenient exposure to myriad segments of the markets. But as ETF asset totals and trading influence grow, opportunities are being generated for discerning investors to feast on anomalously valued, neglected securities sloshing around in their wake.