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.