After the S&P 500 began sinking in 2000, some proponents of index funds criticized the most popular benchmark. The S&P 500 is too volatile, and, being cap weighted, is based on over-valued stocks, they said; so they set about finding better alternatives. Since then a variety of index funds have appeared that weight stocks in the index according to innovative methods. Some of the offerings equal-weight the benchmarks and track that, while others create indexes using fundamental factors (book value, cash flow, price/sales, etc.).
How have the newcomers fared during the turbulence of the past year? Not badly. Consider PowerShares FTSE RAFI 1000 (Symbol: PRF), a large-cap, exchange-traded fund that tracks a fundamental benchmark. During the 12 months ending in June, the ETF lost 21.6 percent, according to Morningstar. That was no cause for celebration, but the fund outdid the S&P 500 by 4.6 percentage points. Other large-cap ETFs that beat the S&P by more than a percentage point include Rydex S&P Equal Weight (RSP) and WisdomTree Total Earnings (EXT).
Besides outperforming in domestic markets, the newfangled ETFs also shined abroad. Foreign funds that outdid traditional benchmarks included WisdomTree Emerging Markets (DEM) and WisdomTree DEFA (DWM), which invests in developed economies.
Despite their recent successes, the new funds have small followings. Most indexed assets still track traditional benchmarks, the approach favored by many academic researchers. The researchers support traditional indexes, such as the S&P 500, because they are weighted according to market capitalization, a straightforward method to track cap-weighted indexes.
Under the traditional cap weighting system, stocks with big market values account for high percentages of their benchmarks. So ExxonMobil, the biggest stock in the S&P 500, is 4.8 percent of the benchmark's assets. Meanwhile, the 50 smallest stocks each account for 0.02 percent or less of assets.
Proponents of cap weighting argue that the system gives a true picture of the market, reflecting the actual holdings of investors. Inventors of other weighting systems assume that there are ways to outsmart the market. That can be a hazardous bet.
Opponents of cap weighting counter that the traditional system has a fundamental flaw — overweighting winners. This became painfully apparent in the late 1990s, a time when technology stocks soared. As stocks such as Amazon and Cisco Systems posted larger market caps, S&P 500 funds shifted assets away from low-priced stocks into the high flyers. When the rally ended, the S&P 500 collapsed.
To avoid overweighting any sector, some fund companies have offered equal-weight S&P funds. As the name suggests, each one of the 500 stocks has about the same weighting. When a stock enters the benchmark it accounts for 0.20 percent of assets. If a stock climbs to about 0.22 percent, the fund rebalances, selling overweighted shares. Because of the rebalancing, the benchmark constantly sells high-priced winners and buys cheap, out-of-favor stocks. In contrast, the cap-weighted benchmark buys high-priced shares and sells cheap losers.
In recent years, the equal-weighted funds have surpassed the traditional benchmark. For example, Morgan Stanley Equally-Weighted S&P 500 (VADAX), an open-end fund, returned 1.7 percent annually during the past decade, outdoing the S&P 500 by 4 percentage points and surpassing 91 percent of large blend funds. Another fund that topped the S&P 500 during the past decade is Bridgeway Blue-Chip 35 (BRLIX). This holds roughly equal amounts of 35 of the largest stocks.
Can the equal-weighted funds outpace the traditional benchmark over the long term? Perhaps. Compared to the conventional benchmarks, the equal-weighted funds give greater weight to smaller stocks and names that fit in the value style box. Such unloved shares have outdone the cap-weighted S&P during the past year and over longer periods.
To be sure, the equal-weighted indexes will not win every year. During periods when large growth stocks lead the market, the conventional benchmark is likely to shine.
While many fundamental indexes have value tilts, some also thrive during growth markets. Under the fundamental system, stocks are weighted to a financial measure, such as dividend yield or earnings. For example, WisdomTree Total Dividend (DTD) gives the greatest weight to stocks that pay out the most dividends. If a company increases its dividend, the weighting could grow — even if the shares fall in price. PowerShares FTSE RAFI US 1000 and other funds designed by Research Affiliates weight stocks based on a composite of factors including dividends, earnings and sales. So a company with greater sales receives a heavier weighting.
The strengths and weaknesses of the RAFI approach were highlighted in the recent market turmoil. Before the downturn began in 2007, financials accounted for 17.2 percent of the S&P 500 and 18.4 percent of the RAFI benchmark. Then as shares of financials cratered, the sector's weighting in the S&P dropped, hitting around 10 percent by the spring of 2009. Meanwhile, the weighting of financials remained stable in the RAFI benchmark. “The shares of Citigroup and Bank of America may have collapsed, but the banks were still large entities on a host of measures,” says John West, a director of Research Affiliates, designer of the RAFI benchmarks.
The declining weight of financials helped the S&P edge past the fundamental index in 2008. During the second half of the year, the S&P 500 lost 28.5 percent, about half a percentage point better than the RAFI benchmark. But then in 2009, RAFI gained the advantage as financials roared back. During the first six months of 2009 PowerShares FTSE RAFI gained 10.3 percent, seven percentage points ahead of the S&P 500.
Are the equal-weight and fundamental indexes superior to the traditional benchmarks? It's too soon to know, but it is clear that the new funds may be useful additions to some portfolios. The fundamental indexes can help to diversify a portfolio that is heavy with cap-weighted funds, says Otis Carter, a private investment management portfolio manager with Wells Fargo Advisors in Evansville, Indiana. “When we plugged the WisdomTree numbers into a computer, we were shocked at how the funds could help to lower the volatility of a portfolio,” says Carter, who has begun using WisdomTree Equity Income (DHS), a large-cap blend fund.
Critics of the fundamental funds say that they simply resemble value portfolios. Proponents of the funds counter that the fundamental funds truly are new creations. While S&P value index funds only hold stocks in the cheaper half of the benchmark, fundamental funds have both growth and value stocks. The fundamental recipe results in a distinctive approach that can give some spice to traditional portfolios.