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Why ETF Investors Should Look Into Indexing Methodologies

This article was originally published on ETFTrends.com.

Investors can now choose from 2,200 U.S.-listed ETFs on the market with plenty of options for any single investment theme or asset category. While a number of ETFs may seem similar and provide exposure to a specific style, it is still important to know that no two ETFs are the same.

"Seemingly small differences in index methodologies can drive large differences in long-run performance. Digging into the details of index construction and understanding the potential costs and benefits of different methodologies can help differentiate among index funds that are great, good, just OK, or not worthy of your investment," Adam McCullough, a manager research analyst for Morningstar, said in a note.

For example, investors who are interested in the dividend growth theme to access quality U.S. companies with a penchant to grow dividends over time have a number of ETF options to choose from.

For example, the Vanguard Dividend Appreciation ETF (VIG) is the largest dividend-related ETF on the market and tracks U.S. stocks that have increased dividends on a regular basis for at least 10 consecutive year. Similarly, the Invesco Dividend Achievers ETF (PFM) also selects companies that have increased annual dividends for 10 or more consecutive fiscal years.

VIG and PFM "track similar indexes, but small methodological differences between the benchmarks that underpin them have resulted in much different investment outcomes," McCullough said.

For starters, VIG produced an annual return of 8.9% from May 2006 through September 2018, which outperformed PFM's annualized returns by 1.9 percentage points, with similar risk.

While both ETFs focus on U.S. stocks that have raised their dividend payments for at least 10 consecutive years, there are some meaningful differences between their indexing methodologies. Specifically, VIG follows a proprietary eligibility screen, excludes limited partnerships and REITs, and allows more discretion over stock removal and portfolio rebalancing.

McCullough explained that VIG's main driver of the difference compared to PFM may be attributed to Vanguard's proprietary eligibility screen that VIG applies after screening its beginning universe for stocks. Furthermore, VIG can remove stocks between rebalance dates if they no longer pass the proprietary eligibility screen, which has helped the fund avoid the major sector drawdowns.

"Although these differences seem small, they have meaningfully impacted the relative performance of these funds," McCullough added.

For more information on ETFs, visit our ETF 101 category.