The Actively Passive Trend: Indexes Get a Makeover
You would simply take your pick among a small number of index mutual funds that covered a small number of well-known indexes, and you would have a well-diversified, tax-efficient portfolio with rock-bottom expenses.
However, the immense popularity of index funds led to the creation of numerous new stock indexes, as well as the invention of a whole new type of index fund investing through the use of exchange-traded funds (ETFs)—passively managed portfolios that track an index but trade on an exchange like an individual stock.
Last year, our annual guide to exchange-traded funds covered over 70 broad-based exchange-traded stock funds, most of which covered different, albeit primarily traditional, stock indexes. But just when you thought it couldn’t get more complicated—it did.
This year’s crop of new ETFs highlights a growing trend in index fund investing—an attempt to redefine the index concept itself. Although several fund groups had started this trend several years ago, this last year saw an explosion in the number of exchange-traded funds that track non-traditional indexes.
There are two broad themes to these “new-age” indexes:
- Some of the new indexes have been created to change the way stocks are “weighted” in the fund, so that the proportion of a stock in the index is not based on its market capitalization (stock price times number of shares outstanding);
- Many of the newer indexes have been created to allow the use of fundamental “qualitative” factors to determine stock composition, adding a semi-active flavor to the composition of the index.
Why redefine the index concept—aside from the obvious desire to market something “new and different?”
Traditional index funds are a direct product of Modern Portfolio Theory, which is the accepted approach to portfolio management today, and one of its tenets, the efficient market hypothesis.
The efficient market hypothesis, put relatively simply, is that there are so many investors competing to find undervalued stocks that their prices are driven to reflect fair value. That doesn’t necessarily mean that there are no stocks that are mispriced—with the advantage of hindsight, it is clear that at times there are. But because a stock’s current price reflects the consensus opinion of all investors, mispricings are never evident before the fact—when you are making the investment. Thus, the natural outcome is a market in which it is virtually impossible to earn a market-beating return with a market-level of risk over the long term by searching for mispriced securities.
Advocates of the efficient markets theory suggest that, instead of trying to find undervalued securities, investors should buy and hold “the market.” In so doing, you would match the market’s gross returns, less expenses, which tend to be held to a minimum with a buy-and-hold strategy. Based on this concept, index funds developed and blossomed into a major market segment.
But criticisms of the approach have arisen over time.
One criticism of the index approach is that particular stocks tend to dominate the “total market” as it is traditionally defined. The “total market” is defined as the sum of all stocks in the market in proportion to their market capitalization—that is, the market is capitalization-weighted.
And that means that larger companies are held in greater proportion than smaller companies, with larger stocks affecting the index performance proportionally more. The S&P 500 alone is equal to about 77% of the total market capitalization of all U.S. stocks. In other words, large-cap stocks drive a total stock market index that is capitalization-weighted. If, for example, you were to compare the performance and risk of the Dow Jones Wilshire 5000 index (a total market index) to the S&P 500 index (a large-cap index) you would find that the performance numbers, while not identical, move in the same direction and magnitude.
A newer but similar criticism is that the capitalization weightings of index funds tend to result in dominance by growth stocks. Since the market capitalization of a stock is the stock price times the number of shares outstanding, as the price of a stock changes, its capitalization changes. The index is thus automatically rebalanced every day, but it also means that a stock’s price dictates how much of each firm is represented in the index, and stocks that have hefty price increases automatically become larger holdings.
A third criticism with the index concept is that research has poked holes in the efficient market concept. In particular, there is relatively solid research that supports the notion that certain value approaches, particularly combined with a smaller-firm tilt, can indeed provide market-beating returns without additional risk.
Although these criticisms have been around for a long time, they were largely ignored by the index fund market. But they started to attract investor attention after the 2000–2002 bear market, when large-cap growth stocks took the brunt of the hit.
In that market collapse, large-cap growth stocks lost 55.6%, while large-cap value stocks lost only 14.6% and small-cap stocks lost 21.0%. And many traditional capitalization-weighted large-cap and total-market indexes, such as the S&P 500 and the Dow Jones Wilshire 5000, fell substantially due to losses in large-cap growth stocks because those stocks were held in larger proportion. Investors who thought that they were diversified because they were invested in major market index funds suddenly felt much less diversified than they had realized.
And with that, index fund marketers saw an opening for a whole new type of index fund, introduced by a whole new group of fund families.
Here is a brief rundown of some of the more interesting groups.
The Rydex Fund group was the first to introduce (in 2003) an equal-weighted exchange-traded fund, the Rydex S&P Equal Weight Fund, which holds all stocks in the S&P 500 in equal portions.
Their series of Pure Value and Pure Growth funds (in various market capitalization ranges) are based on indexes that weight stocks according to their relative S&P style score and not by market capitalization.
The WisdomTree funds all track what the group calls “dividend-weighted indexes,” based in part on the research of Wharton Finance Professor Jeremy Siegel, an advisor to WisdomTree Investments. Siegel prefers the use of dividends in evaluating stocks, arguing they are objective, transparent and less likely to be manipulated by corporate managers who tinker with accounting assumptions; he also argues that dividend indexes have better risk and return characteristics than capitalization-weighted indexes.
WisdomTree dividend indexes are weighted based on either the total cash dividends companies pay (for 18 funds) or their dividend yield (for two funds). That means that securities of companies that pay higher amounts of cash dividends or have higher dividend yields generally are more heavily weighted in each index and fund. Only regular dividends (established or quarterly dividends as opposed to non-recurring or special dividends) are included in the determination of cash dividends or dividend yield.
The funds encompass all of the various market sectors, including large, medium and small cap, plus a number of foreign markets.
The PowerShares Group has several different kinds of non-capitalization-weighted funds.
The PowerShares FTSE RAFI US 1000 Portfolio, despite its unrecognizable name, is one of the more interesting new additions. The “RA” in the name stands for Research Affiliates, an advisor to the fund, whose chairman is Robert Arnot, well-known in the finance community as editor of the Financial Analysts Journal. Arnot has long advocated using fundamental measures such as a company’s sales, revenues, book value or earnings rather than market capitalization to weight the holdings in an index.
The new PowerShares fund is based on an index designed to track the performance of the largest U.S. equities, selected based on four fundamental measures of firm size: book value, income, sales and dividends. The 1,000 equities with the highest fundamental strength are weighted by their fundamental scores, and the portfolio is rebalanced and reconstituted annually.
The majority of the PowerShares funds are based on what it terms “Intellidexes”—semi-active index funds that use certain fundamental characteristics (a “proprietary qualitative method”) to select the stocks in the index, with the proportion held in each stock based on an equal-dollar weighting. These indexes are rebalanced quarterly.
Two PowerShares funds, the Zacks Small Cap Portfolio and the Zacks Micro-Cap Portfolio, follow equal-dollar-weighted indexes designed to identify companies within their size universe with potentially superior risk/return profiles as determined by Zacks Investment Research. These indexes are reconstituted quarterly.
The First Trust group has several interesting non-cap-weighted ETF offerings.
The most unusual is the IPOX-100 Index fund, which tracks a fundamental-based index of initial public offerings (IPOs). The index measures the performance of the top 100 companies in the U.S. IPOX index ranked by market capitalization; the stocks that make up the index are selected based on “quantitative initial screens.”
The First Trust group also introduced the NASDAQ-100 Equal Weighted Index fund, consisting of all NASDAQ 100 stocks held in equal proportions.
Another interesting offering is the First Trust DB Strategic Value Index Fund, based on the Deutsche BankCROCI US+ Index. CROCI stands for Cash Return on Capital Invested, an approach that makes “adjustments to company financial statements in order to make their price-earnings ratios comparable across sectors as well as markets.” The index is an equal-dollar-weighted index that starts with the 251 largest market capitalization stocks in the S&P 500 (excluding financials); the 40 stocks with the lowest ‘economic’ (adjusted) price-earnings ratios are included in the index. This index is reconstituted monthly.
The successful history of traditional index funds indicates that few professional fund managers can beat the market over the long run.
But what about this new crop of “beefed up” index funds?
Whether they can “beat” traditional index funds is anybody’s guess. You could get a Ph.D. in finance and still not resolve the issue, because the academics continue to hotly debate it. The issue will not be resolved until these funds have passed the real time test—that is, they have performed well going forward in time, through varying real market environments.
But here are some thoughts to keep in mind when perusing the new offerings.
First, it is clear that a single index fund is not going to provide you with sufficient diversification for your portfolio, whether it be a fund that follows a traditional market-cap-weighted index or one of the new breed of non-cap-weighted indexes.
Any market-cap-weighted index will be dominated by larger firms. You can overcome this problem using traditional cap-weighted index funds by making sure you invest in index funds that specifically cover the mid-cap and small-cap markets in addition to a large-cap holding. Equal-weighted index funds also solve the problem. Funds indexed to a total market index will not work—they will effectively follow large-cap stocks.
However, fundamental-based indexes are not immune to this problem. They will be dominated by stocks with other characteristics. For example, a number of the WisdomTree dividend-based indexes are heavily populated with REITs. And, of course, they have no stocks that do not pay dividends. Other non-cap-weighted indexes will be dominated by stocks that have the characteristics of whatever selection method they are using. You may want to tilt your portfolio to a particular style because you feel that it will outperform—but just make sure you understand that that is what you are doing. Second, the non-cap-weighted funds do come with some extra costs attached. For one, they tend to have higher expense ratios. More importantly, unlike cap-weighted index funds that automatically rebalance when market prices change, non-cap-weighted indexes must be rebalanced periodically to reflect market changes. That will result in more transaction costs in the underlying fund (which must match the index), and it will expose you to more taxes if you hold the fund in a taxable account. The more frequent the rebalancing, the greater the costs and tax exposure.
With the expanding concept of the “index fund,” you can be sure that your choices will soon increase exponentially. Are too many choices making your head swim?
You can keep it simple by just narrowing your choice among the traditional array of well-known cap-weighted indexes. [See “The EZ Approach to ETF Portfolio Building” in the October 2005 AAII Journal.]
But the new index offerings can add a little bit of fizz to a traditional portfolio, with less risk and lower cost than picking a fully active manager.
The equal-weighted, broad-based funds do offer a cost-effective way to protect against large-cap dominance without holding several funds.
And if you want to dabble in IPOs, add a slight value or growth tilt, or ratchet up your dividend income, these funds allow you to do so without going actively overboard.