Fundamental 'Indexing'

During the 1990s, S&P 500 index funds were all the rage — and, for most core investments, the bogey to beat. But lately the index has been offering stingy returns: During the five years ending in April, the S&P 500 averaged just 2.7 percent annually, well below the double-digit results that many retail clients were seduced into thinking were normal.

Today, there are loads of new “index” funds that claim to reduce what they see as a flaw in the S&P 500: because it is market-cap weighted it gives too much exposure to hot stocks, since those that sport the highest market cap are not always rationally priced. Consider that, together, the biggest 100 stocks in the S&P account for about 70 percent of assets. In short, the S&P tends to produce a large-cap growth investing vehicle. The 1990s demonstrates the flaw. During the great bull market, big growth stocks reached unsustainable heights while value names were given scant attention. Anyone who invested in the S&P 500 index was, sometimes without knowing it, chasing a handful of large, overvalued stocks. By following the S&P, investors systematically overpay, critics contend.

Equal Representation

To avoid emphasizing the market's most popular names, some critics have suggested giving an equal weight to each of the 500 S&P stocks. In an equal-weighted index, General Electric accounts for 0.20 percent of assets, the same figure as every other stock. “With an equal-weighted index you get more diversification because more assets are in small and mid-sized names,” says Tom Lydon, president of Global Trends Investments, a registered investment advisor in Newport Beach, Calif.

With small stocks hot lately, equal-weighted funds have produced strong returns. In the past three years, Rydex S&P Equal Weight, an exchange-traded fund, has returned 22.2 percent annually, more than 6 percentage points ahead of the S&P 500. Morgan Stanley Equally-Weighted S&P 500 A, a conventional mutual fund, has returned 20.7 percent. When the Morgan Stanley fund began in 1997 it attracted little attention as investors focused on old-fashioned index funds. But lately, equally weighted funds have been gaining more followers. The Morgan Stanley fund now has $2.2 billion in assets while the Rydex fund has $1.6 billion. For some advisors, the equal-weighted funds are particularly attractive because they rebalance every quarter. “We are regularly selling stocks that outperformed and buying shares that underperformed,” says Tim Meyer, ETF business manager for Rydex.

Proponents of traditional S&P indexes argue that the lack of rebalancing provides a truer picture of the real market and the economy, where some stocks do extremely well. “If you want to passively track the market then you need to use a capitalization-weighted index,” says David Blitzer, chairman of S&P's index committee. “Any other weighting system involves making an active bet on small-caps or some other segment of the market.” Blitzer says that using an equal-weighted index fund can be a sensible strategy if you want to emphasize small stocks.

Active Indexing?

Along with equal weighting, another alternative approach is known as fundamental indexing. This system weights companies according to several measures, like sales or book value. A company with more sales has more weight in the index. A pioneer in the approach is Robert Arnott, chairman of Research Affiliates, an investment-advisory firm in Pasadena, Calif. The firm uses an approach called Research Affiliates Fundamental Indexes (RAFI) to rank stocks according to several economic measures. To determine the weighting for General Electric, the RAFI system starts by noting that the company accounts for 4 percent of all corporate sales, 3 percent of total book value and profits and 2 percent of all dividend payments for the whole market. Then Arnott takes the average of the different measures and allocates 3 percent of his index's holdings to GE shares.

The RAFI portfolios have shown strong performance in recent years, but S&P 500 loyalists point out that Arnott's approach gives greater weight to value and small stocks, the groups that have done best lately. Critics say it is just another form of chasing the hot dot. “This is an interesting vehicle for investors who want to emphasize value stocks, but the index does not give you broad exposure to growth stocks,” says Baie Netzer, an analyst with No-Load Fund Analyst, a newsletter in Orinda, Calif.

Arnott is not discouraged by such talk. He says that for the 43 years ending in 2005, his RAFI measure would have, on average, outperformed the S&P 500 by more than 2 percentage points annually; it also worked in the past six (if you believe back testing is a reliable measure of past performance), beating the S&P 500 by 6 percent per year. The index technique worked in all 10 of the S&P's major industry sectors. “The capitalization-weighted indexes have a bias toward growth stocks, and we are flat neutral,” says Arnott. “The S&P 500 systematically overweights every company that is trading above its fair value. We succeed by not overweighting overpriced companies.”

Besides delivering strong (theoretical long-term) returns, the RAFI portfolio produces lower volatility than the S&P 500 does. One may argue that past returns do not guarantee future results, but Arnott argues that a traditionally weighty S&P fund will always be more volatile, because, by definition, it overweights growth stocks that tend to be more volatile than value shares. Investors who like Arnott's theory can invest in a new ETF, PowerShares FTSE RAFI U.S. 1000. Another choice is PIMCO Fundamental IndexPLUS, which is a complicated hybrid because it uses a combination of PIMCO's bond-trading expertise and Arnott's indexing theories in an attempt to outdo the S&P 500 (the fund can be purchased through PIMCO). Arnott's firm Research Affiliates also offers a separate account version, but it comes with even a further twist, which he calls his “enhanced” indexes. To boost results, Arnott underweights members of the RAFI portfolio who seem to be in trouble (i.e., sales declining) or use aggressive accounting. In some cases, he overweights companies based on their aggregate sales and de-emphasizes book value measures. It's a complicated formula, but Arnott says, “It is relatively easy to beat our index by changing the formula a bit.”

Arnott concedes that his (back-tested) margin of outperformance over the last six years is bigger than what he would normally expect. “The gap was abnormal because cap weighting produced an abnormally large drag after the 1990s bull market ended,” he says. “Our index is not actively managed to add value. Cap weighting is flawed, and so it loses value.”

Not Your Father's Index Fund