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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Over the long haul, investors in the RAFI funds should earn fairly comparable returns to those of traditional indexes. But that may not hold true for other new-generation index funds making their way into the marketplace.
New York City's WisdomTree Investments, for example, weights companies by their cash dividends. In June, WisdomTree launched 20 ETFs based on its own dividend-weighted indexes. Weighting by dividends steers these indexes sharply away from fast-growing companies, which often don't pay dividends. But WisdomTree's backers, who include Wharton School professor and Kiplinger's columnist Jeremy Siegel, argue that dividend-paying stocks beat the market over time. If you're high on dividend-paying stocks -- and there are many reasons to be (see "Dividends With Room to Grow," Feb. 2006) -- these indexes are worth considering. Just don't use them as direct substitutes for broad-based index funds. For example, WisdomTree Dividend Top 100 (DTN) has 58% of assets in financial and utility companies.
Wheaton, Ill.-based PowerShares takes selective indexing a step further, using 25 factors to construct so-called intelligent indexes. The goal of these Intellidexes, created with the American Stock Exchange, is not to match the market but to beat it. The factors, which include measures of value, price momentum, risk and timeliness, are intended to highlight companies with "the greatest investment merit," says Bruce Bond, PowerShares' president. An ETF based on its large-company index, the 100-stock PowerShares Dynamic Market Portfolio (PWC), returned an annualized 16% over the past three years to August 1, compared with 11% for the S&P 500 (24 Intellidex-based ETFs already trade; 31 more await regulatory approval).
But it's impossible to know whether these indexes can retain their edge. Although PowerShares discloses generally how it determines its indexes, exact formulas are secret. You're essentially buying a "black box" strategy with a short track record.
Also keep in mind that fundamental indexes are frequently rebalanced because of changes in factors such as dividends and cash flow. That means these funds buy and sell more often, driving up trading costs. Moreover, the expense ratio of the RAFI ETF is 0.6% annually, nearly seven times that of the lowest-cost S&P 500 ETFs.
Arnott argues that the performance of funds based on RAFIs will more than offset the higher expenses. But his confidence is based on his indexes' performance in hypothetical tests using historical data. It is possible that the markets will continue to act as they have in the past. But then again, markets love to change course when you least expect them to do so.
The index boom: How three market measures compare
Understanding what makes indexes tick isn't just an academic exercise. Investors, who have poured billions of dollars into traditional S&P 500 index funds, are being wooed by funds that track new kinds of indexes that may -- or may not -- improve on the tried and true. Consider these three indexes that track large-company stocks.
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Data to August 1. *Based on trailing 12-month earnings. Sources: Research Affiliates, Rydex Investments, Standard & Poor's.
