ETFs That Don't Follow Indexes

Tuesday's Wall Street Journal carried a piece titled ETFs Redefine What is An 'Index', which reported on a new trend in ETFs. The first ETFs tracked known market benchmarks, like the S&P 500 or the Dow Jones average. However, since most of the well known indexes are taken, Amex has started offering ETFs that track "rules based portfolios".

What's a rule based portfolio? It's a portfolio constructed based on some rule, or algorithm. An example might be "the stocks in the lowest decile of Earnings-price ratios" or "all mid cap stocks that have had 5 years of greater than 10% annual revenue growth".

So what's the difference between a "rule based portfolio and an actively managed one? I can't see one, but the proponents of these funds say that the algorithm will be executed entirely by computer, so there's no human judgement or discretion involved.

It's an interesting concept, and one that might spark a lot of classroom discussion. Here are a few questions I'll be asking my investments class:

1) What's the difference between a rule-based ETF and an actively managed mutual fund?

2) What role might these funds play in an investment portfolio?

3) If these ETFs become more popular (and I bet they will), how will it change the nature of the investment process (for either individuals or professional money managers)?

4) Will these ETFs eliminate the need for security analysis?

As I said, interesting stuff. And they pay me to do this. Amazing.