You could call it the Battle of the Indexers. On one side are investors who believe traditional market-cap-weighted index ETFs have withstood the test of time and continue to represent the most efficient way to invest in the markets. On the other side stand the growing ranks of alternative indexers who question the efficacy of market cap weighting and believe there are better ways to skin the indexing cat.
In many ways, they are both right. While the newer indexes eliminate some of the inefficiencies of market-cap weighting, they also introduce their own biases. And while they have often outperformed their market-cap-weighted siblings since their introduction over five years ago-a point that the ETF sponsors often highlight in presentations to advisors-they can also be more volatile.
The seeds for alternative indexing were planted back in the beginning of 1998, when technology stocks were just beginning to bubble. At the time, the sector made up 13% of the S&P 500 index. By March 2000, after the tech boom, they accounted for nearly one-third of that sector allocation. The techastrophe that ensued soon afterward launched a new line of thinking by highlighting what alternative indexing advocates consider a fundamental flaw of traditional market-cap-weighted indexes: that they overweight overvalued companies and underweight undervalued companies.
Since then, ETF providers have been busily launching funds based on what they consider new and improved indexes. Depending on their framework, they might rejigger existing components of market-cap-weighted indexes, use the parts that fit their styles and add a dash of their own seasoning, or start fresh altogether.
Fundamentally weighted and equal-weighted indexes have emerged as the dominant challengers to traditional market-cap-weighted products. Together, the ETFs that follow these alternative strategies had some $40 billion in assets in 140 products at the beginning of this year, according to ETF commentary and research site IndexUniverse.com.
In an equal-weight index, each stock or sector component makes up the same percentage of the index. For example, the oldest and largest equal-weight index, the Rydex S&P Equal-Weight ETF (RSP) does what its name implies by taking the component stocks in the S&P 500 index and giving them roughly equal billing.
Tony Davidow, managing director at Rydex SGI, says that equal weighting avoids the problem of emphasizing one stock or sector too heavily, while the practice of quarterly rebalancing helps weed out overvalued stocks. "If you're trying to 'own the market,' it makes sense to have a broad-based representation of what the market is," he maintains.
Fundamental indexing adds a layer of complexity by selecting indexing components based on financial screens such as earnings, dividends or a composite of such criteria. Unlike equal-weighted indexes, which invest in market-cap index components in different proportions, the fundamental indexes sometimes draw from a different pool of securities. Because of the different holding criteria, fundamental index ETFs can differ greatly from one other in composition and performance, besides differing from market-cap-weighted indexes.
PowerShares introduced the first fundamental index ETF in 2005, the FTSE RAFI U.S. 1000 Portfolio (PRF). Based on methodology developed by Research Affiliates LLC, the ETF allocates stocks in the Russell 1000 Index based on a combination of book value, cash flow, sales and dividends. The firm has a total of six fundamental index ETFs based on Research Affiliates' methodology.
WisdomTree, another indexing stalwart, puts its own spin on indexing by emphasizing cash dividends or earnings. That firm, with former hedge fund manager Michael Steinhardt serving as its chairman and Wharton professor Jeremy Siegel as its senior investment strategy advisor, launched its family of ETFs in June 2006. Other major ETF sponsors such as Schwab, Vanguard, State Street and BlackRock also have a smattering of alternative index products in their lineups that use a variety of criteria to build components.