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)
Performance
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

The Vanguard index fund is a regular index weighted by market cap. It is an excellent fund, but it does not have a dividend focus. And that's a big drawback, because the stocks of companies that pay dividends tend to give better annual returns -- and lose less when the stock market corrects -- compared with those that don't pay dividends.

The other four products -- the PowerShares FTSE RAFI US 1000 Portfolio ( PRF), the PowerShares Dividend Achievers ( PFM), the WisdomTree Dividend Fund ( DTD) and the WisdomTree Dividend Top 100 Fund ( DTN) -- are exchange-traded funds, or ETFs, which trade like stocks. And they all focus on dividend-paying stocks. (PRF, DTD, and DTN are full-fledged fundamental indices.)

PFM focuses exclusively on the stocks of companies that pay dividends, but it weights them in a typical market-cap manner. It is not a fundamental index; it simply gives you a market cap-weighted basket of dividend-paying stocks. The focus on dividends is admirable, but investors can do better.

PRF, on the other hand, selects and holds equities using four fundamental measures: sales averaged over the prior five years, cash flow averaged over the prior five years, the latest available book value and total dividend distributions averaged over the prior five years.

It gives equal weight to each of these four measures, then prorates your investment among the companies with the highest collective score. So dividends are a key part of the weighting process, but only one of four equal measures. (And by the way, the letters RAFI in this fund's name stand for Research Associates Fundamental Index. It is the brainchild of Arnott and Hsu, who are building indices based on their research.)

WisdomTree takes another approach. It weights stocks in its index on the basis of either projected dividends or actual dividend yields, its sole screening factors.

WisdomTree's index funds were launched in June 2006, so full-year performance numbers are not available. (Likewise, only year-to-date data are available for PRF at this time.)

Even so, you can see some appreciable short-term performance differences between the fundamental index funds and Vanguard's standard, nondividend index fund.

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 BAC ExxonMobil XOM
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%
Source: Morningstar

Of the four, the one that weights dividend-paying stocks by market cap, PFM, has the strongest weightings for Bank of America and Exxon Mobil shares. It gives investors heightened concentration, which can be a problem if a stock falters.

DTN, on the other hand, is weighted on a dividend-yield basis, and that completely knocks Exxon Mobil off its list. (Dividend yield is simply dividends per share divided by share price.) So it looks for dividends at the right price. That's an important feature, because it means investors won't be swept into speculative, overpriced stock holdings.

All of these dividend-focused funds are good bets for investors looking for long-term gains, but I believe that PRF and DTN will be particularly profitable: They give you relatively less concentration in any single stock, and their weighting methodology of selecting stocks on the bases of dividends and good pricing is a sure-fire way of achieving investment success. They are funds well worth considering.
At the time of publication, Schlagheck was long PRF and DTN. Jim Schlagheck is a wealth-management professional who has counseled ultra-high-net-worth families, endowments and pension funds in the U.S., Europe, and the Middle East. He is a former senior executive of American Express Bank, UBS AG, Bank Julius Baer, and TAIB Bank. During his career, Schlagheck launched a family of mutual funds (now holding $4 billion), led teams of financial planners and investment advisers based in New York, Bahrain, and Geneva, Switzerland, and helped many high-profile clients to protect and enlarge their wealth. Jim has a blog on investment topics www.invest-blog.com and is the author of "Show Me The Money!", a soon-to-be-published book that synthesizes his novel views about investing for retirement.

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