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• The World's Most Misleading ETF Names
• What’s Up With Banks?
• The KBW Index Shuffle

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It began in late October, when State Street changed indexes on five financial ETFs. It shelved benchmarks provided by KBW in favor of a quintet from S'P.

A week later, on Nov. 1, Invesco PowerShares launched four ETFs using four of those ditched KBW indexes that had formerly been tracked by SPDRs.

KBW’s Director of Research Frederick Cannon told IndexUniverse at the time that the KBW index model “more closely mirrors what investors consider when they think of the market-cap universe of large-cap banks.” He correctly pointed out that the S'P indexes are equal weighted.

There’s more to it, though, because the KBW indexes aren’t purely market-cap weighted either. In fact, one of the new ETFs—the KBW Regional Banking Portfolio (NYSEArca:KBWR)—is equal weighted too.

Still, KBWR and its SPDR counterpart, the SPDR S'P Regional Banking ETF (NYSEArca:KRE), only share 67 percent of their portfolios by weight, which suggests Cannon may have had a point when he argued that KBW has a “more rigorous” method of assigning stocks to categories than under the S'P rubric.

The remaining three new PowerShares ETFs—the PowerShares KBW Bank Portfolio (NYSEArca:KBWB), PowerShares KBW Capital Markets Portfolio (NYSEArca:KBWC) and PowerShares KBW Insurance Portfolio (NYSEArca:KBWI)—all track what KBW calls “float-adjusted modified capitalization-weighted” indexes.

That’s quite a mouthful. So what exactly do these indexes entail?

First of all, KBW limits its indexes to the 24 biggest companies by market capitalization in each respective category. In contrast, the SPDR S'P Bank ETF (NYSEArca:KBE) holds 40 securities, the SPDR S'P Capital Markets ETF (NYSEArca:KCE) holds 46 and the SPDR S'P Insurance ETF (NYSEArca:KIE) holds 43.

KBW’s index methodology document describes its modified capitalization-weighting scheme as “a hybrid between equal weighting and conventional capitalization weighting.” That means:

• The largest security’s weight is capped at 10 percent
• The weight of all securities with 5 percent or higher are together capped at 48 percent
• If the largest security’s weight is greater than 10 percent, all securities weighted at 10 percent or higher are reduced to 8 percent.
• If the securities with over 5 percent weightings exceed 48 percent of the index, their collective weights are reduced to 40 percent. The extra weight, in this scenario, is redistributed equally to the smaller securities in the index.

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Also, KBW rebalances its indexes quarterly to maintain these caps.

The KBW indexes are undoubtedly more focused on large-cap companies, even before the weighting differences are taken into account.

Still, it’s a stretch to say that they accurately capture the U.S. large-cap banking, capital markets or insurance industries.

According to the Thomson Reuters business classification system, Wells Fargo makes up about 19.6 percent of the U.S. banking industry’s market capitalization. JPMorgan Chase is close behind with 18.9 percent, and Citigroup makes up a still-sizable 11.8 percent. All three of these securities, under KBW’s methodology, would be capped at 8 percent.

The story is the same with the capital markets and insurance industries ETFs using KBW indexes.

So how different are the two indexes? Depending on your time frame, your choice can have a sizable impact on your returns.

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Over the past five years, the S'P Select Capital Markets Index has outperformed the KBW Capital Markets Index by 12 percent.

Over the same period, the KBW Insurance Index practically overlapped the S'P Insurance Select Industry Index.

If, however, you limit your time frame to three years, the KBW Banks Index outperforms the S'P Banks Select Industry Index by 11 percent. At one point, in April 2010, the KBW index was beating the S'P Index by 25 percent.

Note:All S'P index data prior to 9/12/11 is back-tested.

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For investors who want large-cap exposure to the above-mentioned industries, the KBW indexes—and the PowerShares ETFs that track them—are your best option.

But for those who, instead, are interested in a more diversified set of companies, the S'P indexes—and the SPDR ETFs that track them—are there for you.

Some ETF insiders think a money dispute was the real story behind SSgA dumping the KBW indexes, but for those looking beyond that, there are clear differences between the KBW and S'P indexes that advisors and investors alike ought to understand.

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Don't forget to check IndexUniverse.com's ETF Data section.

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