Shooting for the stars

There is a lot to like about index funds — 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
— 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
— and just about any actively managed mutual fund — 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 — 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.