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When constructing a portfolio, most investors focus on the decisions that seem to have the most significant impact on the risk/return profile delivered. How much should be allocated to stocks vs. bonds? What breakdown between developed and emerging markets is desired? What sectors should be overweight, and which should be avoided?

1. Weighting Methodologies

Many ETF investors pay a great deal of attention to certain attributes of their equity exposure, such as the size and location of the underlying firms. Some details, such as the weighting methodology used to determine the weights assigned to the underlying holdings of a fund, can be easy to overlook. But the manner in which weightings are computed by an underlying index can actually have a major impact on the returns of an ETF, suggesting that perhaps more consideration should be afforded to selection of an appropriate methodology.

Consider the following six ETFs that offer exposure to large cap U.S. equities. While the composition of all ETFs isn't identical, the overlap between these funds is considerable (in some cases, such as RSP / SPY / RWL, the underlying holdings are identical). But the returns generated by these funds in 2010 were very, very different:

The delta between RSP and SPY-more than 600 basis points-demonstrates the importance of weighting methodologies. Both funds invest in the stocks that make up the S&P 500; SPY weights according to market capitalization, while RSP gives an equal weighting to each component. That may seem like a relatively minor distinction, but it translates into a considerable difference in return.

It should be noted that the above table reflects results for a relatively short period of time (one year). While it isn't safe to assume that equal weighting will always outperform cap weighting or that earnings-weighting will always be a laggard, it is fair to conclude that the weighting methodology employed can have a significant impact on return.

2. Style vs. Pure Style

One of the simplest and most common ways to bifurcate stocks involves breaking up the universe of equities into growth companies and value companies. Value companies are those that feature low price-to-earnings and price-to-book ratios and high dividend yields. Growth companies are those that feature higher valuation multiples and lower dividend yields (which are often accompanied by greater prospects for future earnings growth).

This classification system logically leads to investment strategies; some investors believe that value companies perform better in certain environments while growth companies will outperform in others. And of course there are a number of ETFs offering exposure to both value and growth subsets of various market capitalization tiers. Generally, the makeup of these funds will be similar. But the following table might be a bit surprising:

This one might leave you scratching your head as well:

The funds appear to be quite similar, but the performances last year indicate otherwise. A closer look reveals the discrepancies between a value ETF from iShares and a pure value ETF from Rydex.

IVW has 327 individual holdings. The value counterpart-the S&P 500 Value Index Fund (IVE)-has 339. Since both funds offer exposure to subsets of the S&P 500, it doesn't take a mathematician to conclude that there must be some overlap between the two; some S&P 500 constituents are included in both the growth and value funds.

RPG, on the other hand, has about 125 holdings, as does the large cap value counterpart (RPV). These funds focus on the companies that exhibit strong growth or value characteristics, leaving out those that don't fall clearly into one category or the other. Again, it seems like a relatively minor distinction. But the impact on returns can clearly be significant.

Of course, it shouldn't be assumed that the pure style strategies will always outperform the more inclusive style funds. And there are of course diversification benefits to maintaining a larger base of holdings for certain investors. But the point is quite clear; not all growth or value funds are created equal.

3. Small Caps vs. Large Caps

A domestic equity portfolio consisting entirely of the stocks that make up the S&P 500 would likely flunk the "diversification test" of many investors; including mid cap and small cap stocks has the potential to add both diversification and return enhancement benefits. Yet when it comes to international exposure, some investors are content to limit their exposure to the largest of the large companies listed on non-U.S. exchanges.

The most popular international equity ETFs tend to be tilted towards large cap stocks, since the underlying indexes are often cap-weighted benchmarks that consist of the biggest companies in that market. Large cap equity ETFs may be susceptible to a couple of biases. Because the underlying holdings tend to be multi-national companies that generate revenues around the world, the link between the local economy and the performance may be weakened (Coca-Cola (KO), for example, generates the majority of its revenue from outside the U.S.). Second, large cap equity ETFs tend to be tilted towards certain sectors and away from others. Because the largest companies in many economies are banks and oil firms, many large cap international ETFs have considerable exposure to the energy and financial sectors.

In recent years, a number of small cap international ETFs have popped up, and many have drawn significant interest from investors. And, as last year's performance shows, the risk/return profile between large caps and small caps can be considerable:

As the table above indicates, 2010 was a pretty good year for small caps; some ETFs focusing on this corner of the market outperformed large cap counterparts by close to 20%. Again, this won't necessarily be the case every year-large caps will outperform small caps in certain environments-but the massive return gaps is clear evidence that exposure to international equities is not binary. There are a number of different options, and the difference in return (and risk) between large caps and small caps is significant.

4. Hedged vs. Not-Hedged

When considering the primary performance drivers of international equity ETFs, most U.S. investors would focus on the health of the local economy, consumer confidence, unemployment, etc. But for the vast majority of international stock funds, the performance of the relevant country's currency can also have a big impact on bottom line returns. A declining euro, for example, will erode the value of the stocks that make up many of the funds in the European Equities ETFdb Category, just as a strong yen would give a boost to the members of the Japan Equities ETFdb Category.

Most portfolios maintain considerable exposure to exchange rate movements, whether investors know it or not. And while the impact of currency valuations on stock returns will often be minor, it can be material in certain environments.

Currently, there are a couple ETFs out there that hedge out currency exposure. WisdomTree's Japan Hedged Equity Fund (DXJ), for example, seeks to provide exposure to equity securities in Japan, while at the same time hedging exposure to fluctuations between the value of the U.S. dollar and and the Japanese yen. Between the adoption of this strategy in April 2010 and the end of that year, DXJ lost about 7.5%-reflecting a poor performance for Japanese stocks. During that same period, the iShares MSCI Japan Index Fund (EWJ) was up about 5.7%; the losses suffered by Japanese equities were more than offset by an appreciation of the Japanese yen.

The currency hedging isn't the only difference between EWJ and DXJ, but the stocks that make up these ETFs are generally similar. As shown by the big performance delta last year, the "currency effect" on international equity ETFs can be significant. WisdomTree also offers HEDJ, essentially a currency hedged EAFE ETF that makes an interesting option for investors looking to invest in European stocks but concerned about the potential impact of a troubled euro.

5. Front Month vs. Balanced

By now, most investors are well aware that the returns generated by futures-based commodity ETFs aren't likely to be identical to the change in the spot price of the underlying resource, especially over an extended period of time. The slope of the futures curve can have a major impact on the performance of commodity ETPs; when markets are contangoed these products can lag behind the hypothetical spot return, while a backwardated futures markets can give an extra boost to a futures-based strategy.

But for certain commodities, there are differences among the way in which various futures-based products achieve and maintain exposure. Many of the most popular products invest in front-month futures contracts, as these securities tend to exhibit the strongest correlation to spot prices. This strategy will also require the fund to "roll" its holdings regularly in order to avoid taking possession of the underlying assets (which can be a good or a bad thing, depending on the slope of the futures curve). The United States Oil Fund (USO) is one such product; it invests in front month NYMEX crude oil contracts.

There are options for futures-based commodity exposure that don't involve investing exclusively in closest-to-expiration contracts. The holdings of the United States 12 Month Oil Fund (USL), for example, generally consist of the near month contract to expire and the contracts for the following eleven months, for a total of 12 consecutive months' contracts. Such a strategy will generally result in a weaker response to changes in spot prices as well as less vulnerability to the impact of the slope of the futures curve.

Both products invest in NYMEX crude oil futures contracts, but the risk/return profiles are far from identical. Last year, USL added about 6.5% as crude prices spikes. USO actually lost ground on the year (less than 1%), as the adverse impact of a contangoed futures markets canceled out the run-up in crude prices. For an investor who maintained exposure to crude oil last year, the decision of how to weight futures contract maturities was worth about 700 basis points.

Disclosure: Author long BRF

Disclaimer: ETF Database is not an investment advisor, and any content published by ETF Database does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. From time to time, issuers of exchange-traded products mentioned herein may place paid advertisements with ETF Database. All content on ETF Database is produced independently of any advertising relationships.

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