Reinventing the Index
One of the simplest investing strategies is getting more complicated.
By David Landis, Contributing Editor
From Kiplinger's Personal Finance magazine, October 2006
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Modified index funds are not entirely new. In 1987, Morgan Stanley launched a fund that weights every company in the S&P 500 the same. So Morgan Stanley Equally Weighted S&P 500 (symbol VADBX) for the Class B shares) owns, for example, ExxonMobil and Gateway in equal proportions. In 2003, S&P came out with its own equally weighted index, and an exchange-traded fund, Rydex S&P Equal Weight (RSP), tracks it at a fraction of the cost of the Morgan Stanley fund. But even though this equally weighted strategy has trounced the traditional S&P 500 lately (15% versus 11% annualized over the past three years), it's an apples-to-oranges comparison. The equal-weight index owns a much higher proportion of small and midsize firms. If you invest now in the equally weighted index instead of a fund that tracks the regular S&P 500, such as Vanguard 500 Index (VFINX), you'll be shortchanging the megasize companies just as they may be poised for a comeback.
So can you own an index fund that is less vulnerable to market manias but holds stocks in reasonable proportions? Some experts say you can. Arnott is the guiding force behind a set of so-called fundamental indexes that don't take market value into account directly. The Research Affiliates Fundamental Indexes, or RAFIs (named for Arnott's Pasadena, Cal., money-management firm), weight holdings on four factors: sales, dividends, cash flow (earnings plus depreciation and other noncash charges) and book value (assets minus liabilities). These indexes, says Arnott, "measure a company's footprint in the economy." So when stocks' market values diverge drastically from economic fundamentals, as they did during the speculative blowoff of the late 1990s, these re-engineered indexes provide a better measure of value, he argues.
A comparison of the holdings of the flagship RAFI US 1000 with those of the S&P 500 illustrates RAFI's contrarian ways. Overall, the two indexes hold 20 stocks in common among their top 25 (though often in differing order). But RAFI's top 25 includes struggling General Motors, Ford, Merck and Time Warner. It also holds Berkshire Hathaway, which is excluded from the S&P 500 because its high-priced shares trade too infrequently. The S&P 500, on the other hand, holds Cisco and Intel in its top 25, as well as Home Depot, PepsiCo and UPS.
Arnott's firm has created 24 fundamental indexes that track U.S. and foreign stocks. An ETF launched last December, PowerShares FTSE RAFI US 1000 (PRF), tracks the U.S. index. In the first seven months of 2006, the ETF returned 6%, about twice the gain of Vanguard 500 Index. ETFs that seek to track other RAFIs are working their way through the regulatory approval process.
It's hard to draw conclusions about RAFIs' performance from such a short time span. For a clue as to how the approach might fare over the long term, check out a study by Arnott and two coauthors published last year in Financial Analysts Journal. The study found that a hypothetical 1,000-stock fundamental index would have outpaced the S&P 500 by about two percentage points per year, on average, from 1962 through 2004, and with less volatility.
Value against growth
Not everyone buys the idea that RAFIs are better than traditional measures. Skeptics argue that the RAFI performance edge derives from a tilt toward small-company stocks and "value" stocks -- shares of struggling and lesser-known companies that are trading at a discount to their true worth. Small-company and value stocks have performed particularly well over the past few years. Arnott doesn't dispute that but says that even if you disregard the recent past, the RAFI US 1000 looks superior to the S&P 500. Besides, Arnott notes, market-value-weighted indexes have their own biases -- toward big growth stocks.
Not fair, counters George "Gus" Sauter, who used to manage Vanguard's flagship S&P 500 fund and now oversees all of Vanguard's index products. Sauter contends that you essentially bet against the market if you invest in an index fund that isn't market-value-weighted. "Why kid yourself and think you have some kind of superior performance when all you're really doing is getting exposure from a different segment of the market?" he asks. Counters Arnott: "If it works, use it."