Jubak Says: Know Your ETF

02/24/2012 5:00 am EST

Focus: ETFs

Jim Jubak

Founder and Editor, JubakPicks.com

The wide swings in Apple’s stock may have caught some ETF investors off guard, and that is why MoneyShow’s Jim Jubak stresses that you really need to know the composition of your ETF.

This is the great age of index investing. People invest in indexes; they invest in ETFs that are based on indexes. They say, well…active managers don’t produce a whole lot of extra return.

I think the key thing here is if you are going to be an index investor, you need to understand the index. Let’s take a very simple one, the Nasdaq—and more specifically, the more concentrated version of the Nasdaq. Not the Nasdaq Composite, but the Nasdaq-100, which is just the 100 biggest companies in the Nasdaq index.

OK, so what is the biggest company in the Nasdaq index? Well, it is Apple (AAPL) by a long shot. Since these indexes are market cap-weighted, Apple makes up at the moment about 17% of this one index. So you can say this is a lot of other companies and Apple; that is what you are getting if you buy the index.

This means the volatility in a day is largely related to Apple. The whole technology sector can do nothing and Apple can go up and it moves the Nasdaq-100. So on a day like February 15, where we had incredible volatility in Apple—the shares traded in a range for the day of $496 a share to $526, a nice $30 gap, and they finished down for the day about $11—think about the kind of volatility you get.

If you are sitting there looking at the Nasdaq-100 and trying to figure out what is going on, what is going on, should I panic, is it telling me something about the market? No, what it is really doing is telling you something about Apple.

This is true of almost every index. If you are looking at…say you want to buy Brazil, you can buy the iShares MSCI Brazil Index ETF (EWZ). But remember this is also a market cap-weighted index, so what you are really buying is mostly Petrobras (PBR).

So when you buy an index or you buy an ETF, look and make sure you understand exactly what the components of the index are. If nothing else, that will let you sleep a little easier or rest a little easier when you have got a day when the index is moving all over the place, and it is really because of one very overweighted stock.

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