Enhanced indexers say they have the way to go the market one (or two) better.
The beauty of index investing is that its logic is
so simple. Investors, on average, will earn market returns-minus the
costs of buying and holding a market portfolio. For any serious
extended timetable over the past 50 years, you'll see that active
management has consistently delivered lower returns than simple indexes
attached to relevant benchmarks There is one exception, however:
Small-cap growth managers have consistently outperformed over the years.
Still, the message is getting through. Assets tied
to indexed strategies rose from almost nothing to nearly $2.5 trillion
over the past 30 years. Many investors are learning that average isn't
just good, it's great.
Except ... maybe it's not. In the past few years,
indexers have started to suggest that "buying the market" is wrong. Or
rather, that we've been buying the wrong market all along.
The "new new" thing in indexing is indexes that aim
to beat the market. These "enhanced indexes" began to emerge from their
embryonic stage after the huge market correction of 2001-2003, when
investors suddenly realized that tracking the market can lead to some
painful losses. Today, dozens of these new superindexes are on the
market, promising above average returns with below average risk, and
dozens of exchange-traded funds (ETFs) that let investors to play
along.
It pays to be aware of this trend, even if you don't drink all the
"enhanced indexing" Kool-Aid, because more and more indexers are
getting into this game-including such respected names as Standard and
Poor's and State Street Global Advisors-and the funds are so far
delivering results. As these products start to gather some publicity,
investors are going to start asking questions-and financial advisors
better be ready with answers.
What Is "The Market"?
One way these nouveau indexers are attacking
traditional indexes is by questioning their basic design. Author,
editor and uberinvestor Rob Arnott and FTSE recently teamed up to
launch a new suite of indexes that they say will outperform the market
by 2% or more per year.
These are traditional indexes with a twist: Rather
than weighting stocks by their market capitalization, these new indexes
use a series of "fundamental measures"-sales, cash flow, book price and
dividends. Arnott and Co. call them Fundamental Indexes.
"By definition, (in a market-cap index) overvalued
stocks will have extra weight in the index at the expense of
undervalued companies," explained two of Arnott's collaborators, Jason
Hsu and Carmen Campollo, in a recent article in the January/February
2006 Journal of Indexes. "A passive index investor is forced to
allocate more of his portfolio in overvalued stocks and less of his
portfolio in undervalued stocks-exactly the opposite of what common
sense investing would suggest."
It's not really a new idea. We've come to accept
market capitalization weighting as the "correct" way to index, but that
hasn't always been the case. The first index-the Dow Jones Industrial
Average-was (and is) weighted by the price of the shares within the
index. Other popular indexes weight each stock equally. Indeed, the
world's first index fund, launched by Wells Fargo for Samsonite
Corporation, was equally weighted. And both inside and outside the
index industry, investors have long been looking for new ways to
represent the market.
But Arnott's group thinks that it's come up with a
real winner. According to Arnott, the U.S. index (the FTSE/RAFI 1000)
has delivered 2% extra return relative to the S&P 500 on an annual
basis over the long term; international indexes have done even better.
These indexes are attracting a lot of attention-they
won the IMN/IndexUniverse.com award for "Most Innovative Index" in
2005. And PowerShares-a name we'll hear a lot in this
discussion-launched an ETF tied to the FTSE RAFI 1000 on December 19.
But before you get too excited, take a look at this
chart (from JoI) stretching back to 1984. The US RAFI 1000 does not
really begin to outperform the market until the tail end of the
Internet bubble, and the bulk of its outperformance has come in the
past five years. That throws the results into some doubt-the past five
years have been a unique period in market history, with an almost
unprecedented correction to large-cap growth stocks and a strong
performance by value names. It certainly pays to avoid investing in
stock market bubbles-but then again, they may not come along again for
a long time.
It's worth noting that the RAFI data shows
significant outperformance for all styles and dozens of different
country-based markets, dating back many years. Not all of these markets
were affected by the Internet bubble. Moreover, the back-tested data
for these indexes is strong, and the philosophy makes inherent sense.
But given that the bulk of the outperformance came during one of the
most violent market corrections in history, questions remain. And there
are a few academics and indexers who are questioning the data itself-to
see if the historical results are as strong as they appear. The
performance of the ETF will be the true test.
If you buy into Arnott's analysis, you should
realize that it's pretty radical. The idea behind market-cap weighting
is that the market, with its collective intelligence, chooses how to
value companies. The RAFI indexes, in contrast, claim that they know
best; that they've identified the four variables that really matter.
That's a pretty strong statement.
The Momentum Quants
If Rob Arnott wants to avoid the excesses of the
market, the next group-call them the "Momentum Quants"-wants to embrace
them. The quants, like the indexing fundamentalists, believe that they
can identify what makes the stock market tick. But they take things a
step further: They try to combine the best of the Arnott-style
fundamental analysis with the best of the irrational capital markets.
Most keep their methodologies secret, but they all combine fundamental
value-based analysis with momentum trading-buying stocks that are
rising and boosting their earnings estimates, and selling stocks that
aren't.
The quants draw their heritage from the famous stock
market newsletters-Value Line, Investor's Business Daily, Zack's
Investment Research, etc.-all of which use similar screens.
This group of "active indexers" is led by
PowerShares, which has built its rapidly growing ETF business on the
back of these strategies. The bulk of the 30 PowerShares ETFs track
"Intellidexes" from the American Stock Exchange. The indexes are
designed ... here's that phrase again ... to outperform the market with
less risk.
PowerShares launched the first Intellidex funds in
2003, including their flagship fund, a broad-market product called the
PowerShares Dynamic Portfolio (PWC). PWC aims to outperform indexes
like the S&P 500, and using back-tested data, it's done
extraordinarily well, returning 15.76% per year over the past ten years
compared with 9.49% for the S&P 500.
But here's an intriguing thing: The ETF has also performed well in the
real world-doubling the 19% return of the S&P 500 in the two years
since inception. That performance has helped PWC gather more than $650
million in assets. It's hard to get a handle on the sustainability of
the outperformance, since the methodology is secret. But if PowerShares
keeps delivering results, you can expect to see a lot of interest in
these funds.
The Fama/Frenchies
While PowerShares gets all the press, the truth of
the matter is that enhanced indexing has been around for decades.
Dimensional Fund Advisors-a group that distributes its quasi-index
funds exclusively through financial advisors-has been using enhanced
indexing to beat the market for years.
Interestingly, DFA's approach is based on the work
of the founder of pure indexing-Eugene Fama. Fama is famous for
developing the Efficient Markets Hypothesis (EMH), which argues that
you can't beat the market without taking on extra risk. But later in
his career, Fama changed his tune, joining forces with Kenneth French
to propose an improvement on EMH called the Three-Factor Model.
The Three-Factor Model basically says that market,
size and style tilts all factor into market returns, and that,
historically, small and "value" companies have outperformed the broad
market. DFA uses this small/value tilt to construct its index funds,
with a goal of adding 100 to 200 basis points of extra performance per
year.
The funds don't get most press because DFA is
notoriously publicity shy. But they've done quite well. According to
DFA, the Fama/French Large Value Index has outperformed the S&P 500
by 2.5% per year from 1964 to 2000. And that was before the Internet
Bubble burst.
The Dividend Aristocrats
The most recent assault on indexing orthodoxy comes
from inside the bastion of traditional indexing itself-Standard and
Poor's (S&P). S&P recently launched a suite of new indexes that
apply a dividend screen to the S&P 500 Index. In theory, these
indexes are targeted at investors looking for high-yield
investments-similar to the Dow Jones Select Dividend Index that forms
the basis for the $7 billion iShares ETF of the same name. But a close
reading of S&P's promotional literature shows that they have more
than that in mind.
The index getting the bulk of the attention is the
S&P High Yield Dividend Aristocrats Index, which tracks the 50
highest-yielding stocks in the S&P 1500 with a 25-year history of
boosting their dividends. Here's what S&P says about the index:
"(T)he S&P High Yield Dividend Aristocrat Index has shown higher
risk-adjusted returns than the S&P 500, the S&P 500 Equal
Weight and comparable indexes over the past five years."
When the designer of the S&P 500 tells you that
you can beat their own index with less risk, you know that enhanced
indexing has gone mainstream. State Street Global Advisors (SSgA)
wasted no time launching an ETF tied to the High Yield Index.
PowerShares already offers a similar fund called the
PowerShares Dividend Achievers Portfolio, or PFM, based on an index
from Mergent. Mergent says that the index "has outperformed the S&P
500 in the past five-, ten-, 15- and 20-year periods."
Is there an echo?
As with the fundamental indexes, you have to
question the back-tested data on these indexes a bit. That's especially
true for the S&P indexes, which have a number of unique features
that may have skewed performance, such as an equal-weighting system
that introduces a pronounced small-cap bias.
Still, these funds are sure to attract a good deal
of attention-especially if the performance holds up to the billing.
The Wild Card
The wild card in all this is a firm called
WisdomTree Investments. Born from a publicly traded shell company
called Index Development Partners, WisdomTree has spent the past year
building an all-star executive team and promising to launch a string of
ETFs offering ... you guessed it ... above market returns. The firm's board
includes author and academic Jeremy Siegel (of Stocks for the Long Run
fame), hedge fund legend Michael Steinhardt and former American Express
chairman James D. Robinson III; its executive team is pulled form the
absolute top tier of the ETF industry (Barclays Global Investors, Bank
of America, etc.).
Expectations are huge-the company's stock is up
20-fold over the past year, showing that investors are paying
attention. But until the ETFs hit the market, WisdomTree is being very
tight-lipped, and we're left to guess at how they've learned to "beat
the indexes."
Conclusion ... And Why ETFs?
The question is: If it's this easy to beat the
market, then why isn't everybody doing it? These indexes can only work
if the rest of the market is fooled-essentially, if the EMH is wrong.
And that's a bit hard to believe.
It's also convenient that these indexes have all
been launched in the wake of a huge market correction, with swooning
large-cap growth stocks and an unparalleled outperformance by small and
value names. One thing that catches the eye is that three of the four
new methodologies claim to outperform the market by a similar
amount-2-plus percent for the fundamental indexes and the dividend
funds, and 1% to 2% for the DFA product. Only the PowerShares funds
break free, claiming to trounce conventional markets to the tune of 6%
per year (and so far, succeeding).
In the end, these strategies function like active managers on
autopilot. That frees you from the risks of manager error-no small
thing-but you still have to believe that past performance will
translate into future success.
Matt Hougan is assistant editor of Journal of Indexes.