Is There a Better Way to Build Indexes?

 

The classic approach of weighting stocks by market value was beaten by 13 alternatives in one study

  Is your stock index fund leaving money on the table?
New research from Cass Business School in London suggests that the returns of traditional, market-capitalization-weighted indexes trail those of so-called alternative indexes by as much as two percentage points a year over time.
"We're not here to bury cap-weighted indexing as an approach," says John Belgrove, senior partner at consulting firm Aon Hewitt, the Aon PLC unit that sponsored the research. "It has a lot of advantages, especially around transparency. But we want investors to be conscious that it's a choice, and there are other choices available."
Indeed, a bevy of funds tracking alternative indexes have been launched in recent years. And their popularity is soaring: 43% of inflows into U.S.-listed equity exchange-traded products in the first five months of 2013 went to products that aren't weighted by market capitalization, up from 20% for all of last year, according to asset manager BlackRock Inc.
For decades, most indexes have been compiled by weighting stocks according to their total stock-market value, or market capitalization. But critics say there's a problem with that approach: As a stock gets more expensive, its index weighting can grow significantly, leaving the index's overall value more vulnerable to reversals in a few big stocks that have registered significant gains.
Because they are weighted differently, the alternative indexes create more of a tilt toward smaller-cap stocks or value-oriented shares, or both. The long-term tendency of these types of stocks to outperform large-cap stocks and the so-called growth stocks of rapidly expanding companies is so persistent that it has its own name: the Fama-French model, named after the University of Chicago academics who first documented the effect.
The Cass Business School researchers examined how 13 alternative index methodologies would have performed for the 1,000 largest U.S. stocks from 1968 to 2011.
All 13 of the alternative indexes produced higher returns than a theoretical market-cap index the researchers created. While the market-cap index generated a 9.4% annualized return over the full period, the other indexes delivered between 9.8% and 11.4%. The market-cap-weighted index was the weakest performer in every decade except the 1990s.

Two Flavors

The two most common types of alternative indexes are equal-weighted indexes and fundamental indexes.

Equal-weighted indexes simply allot an equal share of the index to each stock. An example is the S&P 500 Equal Weight Index, which has the same constituents as the traditional S&P 500, but with each stock making up 0.2% of the index.
Fundamental indexes, like market-cap-weighted indexes, aim to give more weight to larger companies and smaller weight to smaller companies. But instead of using share prices as a guide, they use a "fundamental" value figure like sales, earnings, book value, dividends or cash flow. Some indexes, like the FTSE RAFI series created by FTSE Group and Research Affiliates LLC, an investment-strategy firm based in Newport Beach, Calif., combine several measures. Others, like the WisdomTree Earnings Index focus on a single measure.

Active Debate

John Ameriks, head of the Active Equity Group at Vanguard Group, acknowledges that many of the new approaches are logical and effective, but objects to them being presented as passive strategies.
"We want investors to understand what they're getting," says Mr. Ameriks. "These are active approaches that tend to load up on particular factors, and if those factors continue to provide the outperformance that they've provided in whatever back tests have been constructed, then the investor will see an excess return—but that's a huge if."
Matt Hougan, global head of content for IndexUniverse.com, hasn't jumped on the alternative-index bandwagon. "My portfolio is 100% market-cap-weighted funds," he says. Still, "investors are always going to look for ways to outperform the market," Mr. Hougan says. And alternative-index funds may be an attractive way to do that with part of one's portfolio, he says, in part because expenses are lower than on most actively managed stock funds.
Low-cost exchange-traded funds tracking alternative indexes are plentiful, although they aren't as cheap as market-cap-weighted ETFs. For example,  Guggenheim S&P 500 Equal Weight has an expense ratio of 0.40%, while the giant market-cap-weighted SPDR S&P 500 charges 0.09%.Mutual funds tracking alternative indexes are also available, but tend to have higher expenses. One lower-cost option is Schwab Fundamental US Large Company Index, which charges 0.32%. It tracks the FTSE RAFI US 1000 index, which includes the top 1,000 U.S. stocks weighted by a combination of book value, cash flow, sales and dividends.

Another option is to use low-cost market-cap-weighted funds and tilt your portfolio consciously toward value and small-cap stocks. This, however, only captures part of the outperformance of the alternative indexes, because the holdings within those funds are still weighted by market capitalization. For example, the  PowerShares FTSE RAFI US 1000 has a five-year annualized return through June of 10.3%, beating the iShares Russel 1000 Value Index's 6.5% and the small-cap iShares Russel 2000 Index's 8.7 %.