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The ETF Book: All You Need to Know About Exchange-Traded Funds, Updated Edition by Richard A. Ferri

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CHAPTER 8

Index Security Selection

Index Strategy Boxes categorize exchange-traded funds (ETFs) according to the construction and maintenance rules of the indexes they follow. The rows represent broad security selection methods, and the columns represent broad security-weighting methods. Knowledge of an underlying index’s security selection and security-weighting methodologies are major steps toward understanding the way an ETF that follows the index is managed.

ETF managers follow indexes in a number of ways. They can completely replicate all the securities in an index, sample the securities in an index, or use derivatives that trade based on their level in an index. The important points for ETF investors are how the index is managed and the characteristics of the index, regardless of the method the fund manager uses to track the index.

The first part of index analysis is the security selection method, and the second part is the security-weighting method. This chapter examines security selection methodology in detail. Chapter 9 examines security-weighting methodologies.

Security Selection Categorization

Index providers publish rules for each of their indexes that describe the security selection criteria. These rules give investors a working knowledge of how that index is constructed. Some index providers supply detailed information; others release minimal information about their methodology. Index providers that use passive security selection methods tend to be far more transparent ...

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