Shooting for the stars

There is a lot to like about index funds â€” low costs and low taxes, for starters. Over any reasonable period, index funds beat 75% of actively managed funds. But despite all those advantages, index funds still can’t guarantee that they’ll make you rich. If you invested in an S&P 500 index fund back in 2000 you know what I mean. More than seven years later, your investment is still lagging behind inflation. Maybe there’s a way to build a better index fund. A growing number of people argue that by fixing a flaw in how index funds construct their portfolios, they can boost performance while keeping intact all the other good things that index funds have to offer. Here’s how their reasoning goes. Most index funds calculate how much of a company they should own by looking at its market capitalization. The market capitalization is the total number of shares on the market multiplied by the share price. If ABC Inc. has issued two million shares, and each of those shares is selling for $10, the company has a market capitalization of $20 million. In contrast, if XYZ Corp. has issued a million shares and those shares are trading at $5 each, its market capitalization is only $5 million. So most index funds would put four times as much money into ABC as XYZ. Still with me? Good, because here’s where things get interesting. If you think about the market capitalization system, you realize that it has a nasty side effect. It ensures that index funds will overweight overvalued stocks. These overvalued stocks are usually high-growth, high-glamor firms in trendy industries. Since these overvalued stocks are trading at higher prices than their fundamentals warrant, their market capitalization is also higher than sanity would suggest â€” and so is their weight in the index. If they don’t live up to the high hopes that have been built up around them, the results can be painful. You may remember how Nortel accounted for about a third of the value of the TSE index back in 2000. That was a classic case of an index overweighting an overvalued stock. As Nortel sank, it took the entire index down with it. The easiest way around the market capitalization problem is to construct your index using some other system for selecting stocks. Take the Vanguard Value ETF as an example. This ETF, which trades on the American Stock Exchange, doesn’t use market capitalization to decide which stock to own. Rather, it tilts its portfolio toward stocks with low price-to-book ratios, low price-to-earnings ratios and high dividend yields. By constructing its portfolio along those lines, it tries to avoid overpriced firms and to invest your money only in fairly valued or undervalued companies. Over the past three years, it has beaten the S&P 500 index by nearly three percentage points a year. Many other approaches are possible, of course. The iShares S&P 500 Value Index fund picks stocks using a different method than the Vanguard fund, but is similar in style, and has outperformed the S&P 500 Index by an average of one percentage point a year over the past decade. A slightly different take is provided by the iShares Dow Jones Select Dividend Index, which invests in large U.S. stocks with high dividend yields and a history of dividend growth. The most ambitious attempt to overhaul traditional indexing comes from Rob Arnott, chairman of Research Affiliates LLC in Pasadena, Calif. He’s pioneered a strategy known as fundamental indexing that weights stocks based on factors such as a company’s sales, dividends, cash flows and book value. His goal is to tie the weight of a company in the index to the size of its fundamentals, so that it’s impossible to overweight an overvalued company. Arnott has back-tested his methods on historical data and claims that his fundamental indexing approach would have outperformed traditional indexes by more than two percentage points a year over the past few decades. That advantage, if it continues to hold true, means that fundamental indexing would have a massive edge over traditional indexes â€” and just about any actively managed mutual fund â€” if held for 10 years or more. Fundamental indexing ETFs are now popping up all over. PowerShares (www.powershares.com), a U.S. asset management firm, offers a fundamental indexing ETF based on what’s known as the FTSE RAFI US 1000 Portfolio. It tracks a thousand U.S. companies weighted by the fundamental factors that Arnott has identified as important. In Canada, Claymore Investments (www.claymoreinvestments.ca) offers a number of similar ETFs that track fundamental indexes in Canada and internationally. I think fundamental indexing is a fascinating idea, but I would urge you to remember that the jury is still out on its performance claims. John Bogle, the father of index funds, has expressed skepticism about whether fundamental indexing adds a lot to traditional indexing. He’s worried that fundamental indexing has yet to prove itself in the real world. While Arnott and his crew have back-tested their strategy on historical data, there’s no guarantee that their fundamental indexing approach has identi- fied factors that will continue to pick winners in the future. It’s possible, too, that fundamental indexing may be merely value investing in disguise. Like a good value investor, a fundamental indexing strategy ensures that you don’t go overboard for whatever sector or trend is running hot at the moment. That’s valuable â€” so long as you remember that value investing doesn’t beat the market all the time. In fact, growth strategies performed better than value strategies for most of the 1990s. If that happens again, both fundamental indexing and value-oriented ETFs are likely to lag behind the plain-vanilla market index for a while. In my opinion, both fundamental indexing and value-based indexes are worth a look, especially if you’re already an index investor. These rule-based strategies offer many of the advantages of traditional indexing, but also hold out the prospect of beating the market. Their great advantage is that they force you to buy stocks at sensible prices. Both may lag behind when growth is in favor, but both are likely to get you where you want to go with a minimum of volatility.

Shooting for the stars

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Shooting for the stars

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