Apple was only the latest mega-cap stock to become the tail that wagged the index dog. Its recent downfall as one of the stock market’s most high-profile constituents has raised renewed interest in exchange-traded funds that follow untraditional indexes.

With market-cap weighting, which most ETFs use, the public value of a company’s stock determines how much real estate it occupies in a particular index. That means the dominant companies and sectors tend to be those that are attracting the most attention from investors. Critics say that feature makes the indexes vulnerable when the market tumbles and “hot” stocks and sectors fall out of favor. That happened in the tech wreck of the early 2000s, when the S&P 500’s huge technology stake played a major role in sending the index plummeting.

More recently, the “Apple effect” has highlighted the vulnerability of the S&P 500 when top holdings tumble. After a meteoric multiyear rise, the stock accounted for nearly 5% of that index by September of last year. And since then, its slump has been a big drag on returns.

Apple’s ups and downs have had an even more profound influence on cap-weighted indexes that track the technology sector (or lean heavily toward it). The Nasdaq 100, which follows the largest 100 nonfinancial securities listed on the Nasdaq, had about 20% of its assets in Apple by April of last year.

“Apple has become the poster child for market-cap weighting,” says William Belden, managing director at alternative index ETF sponsor Guggenheim Investments.

The Guggenheim Equal Weight S&P 500 ETF (RSP) has less than 1% of its assets in Apple, so it hasn’t felt as much of the pinch from Apple’s decline. The fund, which holds between 0.14% and 0.39% of its assets in constituent stocks of the S&P 500, has handily outperformed its market-cap-weighted benchmark since its inception over 10 years ago. It did so even with the heavy 0.40% expense ratio, which is more than four times the cost of the fund’s most popular market-cap-weighted competitor.

Still, alternative index ETFs, which use methodologies other than traditional market-cap weighting, have been the subject of controversy since they were introduced some 10 years ago. While fans say these funds offer a smarter or broader way to invest in the market, opponents say their costs often eat up any of the fleeting performance advantages of their indexes.

That’s significant after a wave of fee cuts in the ETF world. Schwab, Vanguard and iShares investors can now get cap-weighted index ETFs with expense ratios as low as 0.04%, a screaming bargain compared with the 1% or more charged by actively managed mutual funds. Because alternative index ETFs usually require more frequent rebalancing and endure higher turnover, their expense ratios can be four to five times higher. That can be a big drag on returns over time.

Nonetheless, many of these products can fill the gap between actively managed mutual funds and passive market-cap-weighted ETFs, according to John Feyerer, head of product strategy and research at PowerShares. “Initially, the typical user of our alternative index ETFs had invested in ETFs before,” he says. “While we still see that, an increasing number of investors tell us they are converts from actively managed mutual funds who are frustrated by high expenses and poor relative performance.”

Fundamental Indexing
As their name implies, equal-weighted indexes give each component stock in an index roughly equal space. Fundamental indexing is a little more complicated. This quasi-active filtering strategy allocates assets to companies according to their business fundamentals such as earnings or dividends. The biggest player in this area is PowerShares, which offers a suite of fundamental index ETFs developed by Robert Arnott and his firm, Research Affiliates. The indexes base weightings of companies according to their five-year averages of sales, profits and dividends. According to the firm’s Web site, the indexes have “a value tilt and a slight small-cap tilt.” WisdomTree, another major player in the alternative indexing space, also offers exchange-traded funds based on the dividends or earnings of an index’s constituent stocks.

Whether these and other alternative index ETFs are worth the extra cost depends on the ETF and the time frame under examination. Over certain time periods, some market-cap-weighted index ETFs have achieved better performance than their equal-weighted or fundamentally weighted challengers. But some alternative index ETFs have delivered superior performance in certain periods that have more than compensated for their higher expense ratios.

A comparison of the First Trust Nasdaq-100 Equal Weighted fund (QQEW) with the popular market-cap-weighted PowerShares QQQ Trust illustrates those points. Because of its stocks’ equal weighting, the QQEW fund has had a much smaller presence in some of the mega-cap technology names that have led the market, most notably Apple. It also has an expense ratio of 0.60%, while the PowerShares ETF’s ratio is 0.20%. Both factors have hurt the First Trust ETF’s comparative performance over the last three and five years. More recently, however, the “Apple effect” has helped give equal-weighted funds the performance edge. That effect is likely to persist; by March 31, 2013, even after Apple shed one-fourth of its value, it still made up more than 13% of the Nasdaq 100 index.

Even when alternative indexes appear to hold an edge, the ETFs that use them may not. In an article at IndexUniverse earlier this year, author Cris Heaton took a look at returns for five alternative index emerging-market ETFs launched in 2007 and 2008. All of the indexes they followed outperformed the MSCI cap-weighted indexes from inception through 2012, some by a significant margin. However, the net asset values of the funds typically underperformed their benchmarks by one to two percentage points per year because of expenses and index tracking issues.

“While fundamental index approaches in emerging markets continue to claim significant potential added value, investors need to be aware that costs can easily eat away at those extra returns,” Heaton warned.

Despite their higher costs, some alternative index ETFs have managed to outperform their market-cap-weighted counterparts over longer periods. And by using a different set of market exposures, they could provide some balance to a market-cap-weighted portfolio.

The Guggenheim S&P 500 Equal Weight fund invests in the same companies as the market-cap-weighted SPDR S&P 500 fund (SPY), but its equal-weighting feature gives the portfolio more of a value hue and lower average market capitalization. According to Morningstar, the SPDR ETF has 51.53% of its assets in mega-cap stocks, 36.15% in large caps and 12.20% in mid-caps. The Guggenheim ETF has only 11.76% of its assets in mega-caps, 41.96% in large caps and 44.89% in mid-cap companies.

The Guggenheim fund has underperformed the SPDR fund over certain periods, including the first nine months of 2012, when strong results for large mega-cap names swayed returns. But it has beaten the market-cap-weighted ETF by over two percentage points annually over the last 10 years.

Fans of market-cap weighting say that it requires a mid-cap and value bias for success, and that investors in cap-weighted ETFs should thus use those strategies. And they say that the equal-weighted ETF, because it owns a broader subset of smaller stocks, has been more volatile than its traditional counterpart.

Belden disputes the notion that investors can achieve similar results by introducing certain “tilts” into cap-weighted strategies. “Our ETF has a very different set of names than the mid-cap S&P 400 index,” he says. “The big benefit here comes from reducing individual security risk. And over time, we believe the superior returns overshadow the higher volatility.”

On the fundamental indexing front, the $2 billion PowerShares FTSE RAFI U.S. 1000 Portfolio (PRF), has an expense ratio of 0.39%, over twice as high as that of the iShares Russell 1000 Index fund (IWB). Although it’s been a bit more volatile than the iShares ETF, the PRF fund’s five-year annualized return has beaten its competitor’s by a considerable margin.

Much of that outperformance is attributable to its larger allocation toward financial, industrial and other cyclical stocks that fell sharply out of favor in 2008 and 2009. As those stocks rebounded, the ETF galloped ahead. The PowerShares ETF still has a much higher allocation to financial services and energy stocks than the iShares Russell 1000 ETF.

Feyerer says that the outperformance comes from a methodology that ignores market euphoria and fads. “There is much more at work here than just a static value tilt,” he maintains. At the same time, he says, “we believe a market-cap weighting sometimes does better when share prices disconnect from intrinsic value.”

Another fundamentally weighted ETF, the $1.7 billion WisdomTree LargeCap Dividend ETF (DLN), has become a major competitor in the growing investor quest for yield. Its expense ratio of 0.28% compares favorably with the 0.40% expense ratio of the iShares Dow Jones Select Dividend Index fund (DVY). But it is nearly three times higher than the 0.10% charged by the Vanguard High Dividend Yield ETF (VYM).

The WisdomTree index used for this ETF benchmark weights stocks based on the projected cash dividends they will pay over the next year. “This fundamental weighting methodology balances a company’s market capitalization with its dividend yield, so the index isn’t dominated by either low-yielding mega-cap stocks or very high-yielding, risky names (as might result from a naïve, dividend-yield-driven approach),” notes Morningstar analyst Samuel Lee.
But the iShares ETF’s yield-weighting methodology provides a more contrarian play with a stronger value tilt, so it might perform better when beaten-down stocks rebound. Of course, the Vanguard ETF’s razor-thin expense ratio is a rock solid bargain, regardless of what the market does.

Your decision about whether the potential benefits of alternative index ETFs outweigh the added costs might ultimately come down to how their unique approaches are likely to influence performance in a particular market environment.

“Alternative indexes move in and out of favor, just as market-cap-weighted indexes do,” says Adam Patti, chief executive officer at IndexIQ. “They’re a good way to tilt portfolios toward what you believe makes the most sense now.”