A new kind of fund is attracting the attention of investment experts, as well as billions of dollars of pension and private-investor monies. Sometimes referred to as "fundamental indices," these products have exceptional risk and reward characteristics.To understand these new investments, let's take a brief look at the differences between a fund and an index. An actively managed fund -- and there are many thousands of them -- is usually a bundle of, say, 25 to 50 stocks or bonds selected by professional asset managers on the basis of research, earnings, risk ratios and so forth. They are labor-intensive investment structures, they cost a lot to construct and manage, and they are the typical kind of product offered by the majority of 401(k) plans. By comparison, an index is a bundle of stocks or bonds that attempts to replicate an entire market (or sometimes just a portion of one). For example, when you put money in Vanguard's ( VFINX) 500 Index , you are investing in a basket of all 500 stocks that compose the S&P 500's universe of shares. And those stocks are weighted in the index on the basis of their market capitalization, or market cap. Market cap is simply the price per share of a stock multiplied by the number of shares outstanding. Suppose there are two companies, and each has 1,000 shares of stock outstanding. Company A's shares trade at $5 apiece, and Company B's shares trade at $2.50 apiece. A typical index weighted by market cap will buy and hold twice as many shares of Company A relative to Company B. There are many different kinds of index funds, and they have several distinct advantages over actively managed funds.
First, they cost a lot less to manage. In addition, they incur substantially lower trading costs, because there is less buying and selling going on. As a consequence, investors have a smaller portion of their money siphoned off to management fees and trading costs.And here's an important fact: Better performance is undoubtedly the foremost advantage of an index investment. Many academic and professional studies -- by John Bogle, Al Ehrbar, Paul Samuelson and Charles Ellis, to name just a few -- have demonstrated that an index fund is likely to deliver better returns than an actively managed fund if held for a long period -- seven years or more -- of time. As one savvy investor put it: Why beat your brains out trying to outperform the market when you can much more simply and soundly match it?
Buy and Hold High?Regular indices are indeed wise investment choices, but they have a serious flaw: Because they are market-cap-weighted, they give you more exposure in overpriced stocks and less exposure in underpriced stocks. They do the exact opposite of buying low and selling high: they both buy and hold high! Remember the late 1990s and the tech-stock euphoria? Well, regular indices gave investors big doses of hyperinflated stocks during that period. And that is precisely the major problem with most indices: They give you "bubble" positions when such markets form. A number of experts -- including Rob Arnott, Carmen Campollo, Jason Hsu and Philip Moore -- focused on this fact and found that indices weighted on the basis of dividends, revenue, sales, book value or even employee head count -- fundamental indices -- delivered consistent, significant benefits compared with those of standard cap-weighted indices. (For further reading, the Financial Analysts Journal and the Journal of Indexes are excellent sources for information on fundamental indexing.) In other words, these indices, which select and weight stocks in ways other than the typical market-cap method, outperform regular indices, which in turn outperform actively managed funds over the long term. Let's take a look at several fundamental indices and compare them with an ordinary index.
|Index Funds With a Dividend Focus (Oct. 6, 2006)|
|Symbol||Fund Name||# Stocks||Weighting||3 month||1 year|
|PRF||PowerShares FTSE RAFI US 1000 Portfolio||1,000||mix: book value, income, sales, & dividends||5.43%||11.00%|
|PFM||PowerShares Dividend Achievers||317||dividends + mkt cap||6.50%||12.64%|
|DTD||WisdomTree Dividend Fund||1,528||dividends||6.23%||n/a|
|DTN||WisdomTree Dividend Top 100 Fund||100||dividend yields||7.06%||n/a|
|VFINX||Vanguard 500 Index||500||market cap||5.62%||10.63%|
|Source: Morningstar, fund prospectuses, fund Web sites|
Which Way to Go?For all their overall similarity, these new index funds are constructed and weighted quite differently. In practical terms, how advantageous are the various fundamental-index approaches to holding stocks? Which index fund is the best? To answer those questions, let's note that our four fundamental index products funds own Bank of America ( BAC), but in different amounts. In addition, three of the four own Exxon Mobil ( XOM), also in different amounts:
|Levels to Watch|
|Bank of America ||ExxonMobil |
|PRF||PowerShares FTSE RAFI US 1000 Portfolio||1.77%||2.80%|
|PFM||PowerShares Dividend Achievers||4.48%||4.82%|
|DTD||WisdomTree Dividend Fund||4.05%||3.21%|
|DTN||WisdomTree Dividend Top 100 Fund||1.39%||none|
|VFINX||Vanguard 500 Index||1.91%||3.23%|