A Potential Construction Flaw in Index Funds has led to New Generation Index Funds

publication date: Jun 12, 2013
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Back in February, 2011, in an update on the best index and exchange-traded funds (ETFs), I highlighted a new breed of index funds. Rather than weighting the holdings of stocks by the stocks’ capitalization, these new index funds equally weight their holdings of all stocks in a given index, such as the Standard & Poors’ 500 index, or weight them by some measure of company fundamentals.

That article highlighted two ETF equal weighted alternatives to traditional capitalization weighted index funds:
  • Guggenheim (formerly Rydex) S&P Equal Weight (ticker RSP). This ETF holds all 500 S&P 500 stocks in equal amounts (0.2 percent per holding). Thus, compared to a traditional S&P 500 index fund, this fund has more mid-cap and small-cap weighting. Expense ratio is 0.40 percent which is a bit more than a Vanguard index fund or ETF but quite reasonable.
  • PowerShares FTSE RAFI US 1000 (PRF). This ETF has similarities to the Russell 1000 index but weights its holdings based upon fundamentals such as book value, dividends, sales, and cash flow rather than market capitalization. This results in the fund having a slightly more smaller-cap value flavor. Expense ratio is 0.39 percent.

(I have also previously highlighted other ETFs, particularly from WisdomTree, which weight their index holdings using fundamental criteria.) 

As I mentioned back in early 2011, these funds were outperforming comparable indexes and that continues to be true today. Through June 11, 2013, here’s how these two ETFs have performed in comparison to relevant market indexes:

 

 

What $10,000 grew to over five years ending 6/11/13

Avg. annual rate of return five years ending 6/11/13

Guggenheim S&P 500 Equal Weight

$ 15,187

8.84 %

PowerShares FTSE RAFI US 1000

$ 15,443

9.20 %

S&P 500

$ 13,504

6.27 %

Russell 1000

$ 13,669

6.45 %

 

There is, of course, no guarantee that the out performance of these alternative weight index funds will continue. And that leads me to the emerging debate over these new index funds.

Rob Arnott Debates Vanguard Index Pioneer Jack Bogle

Forbes magazine recently published an article entitled “Has Rob Arnott Built A Better Index Fund?” which delved into some of the critical issues in the debate over which index funds are best. Below are the highlights from that article about Arnott’s firm (Research Affiliates) followed by my comments:


 

“Research Affiliates manages $142 billion and could change the way your retirement money is invested, but you won’t find the firm’s name engraved on the white stone and tinted glass of the building in Orange County, Calif. where it is headquartered.

…On Arnott’s own bucket list these days: upending the established world of index fund investing. Vanguard Group founder John C. Bogle started the first market-mirroring index fund in 1975 after academic research–and Burton Malkiel’s bestselling book, A Random Walk Down Wall Street–brought home the point that mutual funds that actively picked stocks earned less than the market as a whole. In the decades since, broad-based index funds have shown they can outperform most actively managed funds most of the time, and Vanguard’s Total Stock Market Index has become the world’s largest equity mutual fund.

But Arnott contends index investors could do even better. Traditional equity indexes, like Vanguard’s, weight their stock holdings based purely on market capitalization. If a stock accounts for 3% of the total market cap of the 500 stocks in the S&P 500, it will represent 3% of the value of an S&P 500 fund. A stock’s price might be inflated and about to plummet back to earth, but a traditional index fund doesn’t adjust for that possibility, because the very foundation of indexing is the belief that trying to outsmart the market is a loser’s game and that by capturing the market’s overall return you end up a winner.

After the rise and fall of dot-com stocks during the first Internet bubble, however, Arnott concluded it would be smarter to build indexes based on fundamentals–not market price–to minimize the impact of investing fads. Research Affiliates’ fundamental indexes (known as RAFIs) rank stocks based on book value as well as trailing five-year average cash flow, sales and dividends. So, for instance, Apple, the top holding in the S&P 500 stock index, is only the 17th largest on the FTSE RAFI US 1000 (the 1,000 largest U.S companies based on fundamentals). The result is that fundamentally weighted indexes tend to put more money into value stocks and shares of smaller companies and less into the market darlings of the moment than do traditional indexes.

…While fundamental indexing is still just a tiny niche–passive index funds and ETFs in the U.S. hold $2.7 trillion–the method seems poised to spread. Schwab plans to launch six ETFs based on Arnott’s indexes, according to its filings with the Securities & Exchange Commission. If Schwab follows the strategy it has used with its other ETFs, fundamental indexing could be a big part of its managed portfolio products and eventually show up in retirement plans.

…Fees are a key sticking point for traditional indexers and for Bogle fans. Fundamentally weighted index funds must charge more in part because it takes more effort to determine (and keep current) the basket of underlying stocks in the index.

…In a recent interview Bogle offered a more tempered critique of fundamental indexing. Since Arnott’s index has more value stocks, he said, during some periods it will produce better results than a market-cap weighted index and in others (such as during the late 1990s, when growth stocks were doing well) it will do worse “and over the long run I believe they will do the same.” But he says there’s no guarantee that a fundamental index will do as well as the market, since it’s not buying the market. And he couldn’t resist adding: “You could argue it’s not even an index fund.”

…So far, however, fundamentally weighted indexing has been less than impressive in the bond market. Traditional bond indexes are based on debt outstanding. Research Affiliates’ bond indexes rank issuers by their economic footprints. For corporate bonds it uses cash flow, sales, dividends and book value of assets. For sovereign debt it rates a country’s total population, gross domestic product, land and energy consumption. High fees and strong competition from actively managed bond funds have hampered the growth of fundamentally weighted indexing in fixed income. PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB) has underperformed the typical high-yield corporate bond fund by an average of one percentage point per year over the past three years…”

My Thoughts on Arnott and his New Breed of Index Funds

Back in April, 2009, almost precisely at the bottoming of the stock market and before it began its huge multi-year advance, I discussed Arnott’s poorly reasoned and analytically flawed work purporting to demonstrate that bonds actually do better than stocks over the long run. Those who rejected Arnott’s advice and took my advice at that time were well rewarded.

Regarding Arnott’s equal weight or fundamentally driven index funds, I think that there is some merit to his ideas as I stated back in my 2011 article on the topic. However, you must be mindful of fees and the fact that high fees can sabotage an index fund. I would not pay more than 0.5 percent for an index or index like stock fund.

The two equal or fundamentally weighted index funds I mentioned earlier in this article appear solid, have reasonable fees and are worth considering as I stated two years ago.

One final point and detail: Forbes made a serious factual error in their article. Their statement that Arnott’s firm, Research Affiliates, manages $142 billion is wrong.

On their website, Research Affiliates states:

“As of March 31, 2013, about $142 billion in assets are managed worldwide using investment strategies developed by RA.”


The firm doesn’t actually disclose on their website how much money they directly manage so I called them and learned that that number is “nearly $7 billion” according to their press spokesperson. Not too shabby but no where near $142 billion!”  

 



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Copyright Eric Tyson, 2008 - 2018 all rights reserved.

Eric Tyson is the only best-selling personal finance author who has an extensive background as an hourly-based financial advisor and who does not accept speaking fees, endorsement deals or fees of any type from companies in the financial services industry or product or service providers recommended in his articles, books and his publications.

 

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