Well, no, in that the construction of an index can play a large part in its returns. For example, most index funds are market-cap-weighted, meaning that the largest stocks drive the index's overall performance. Such an imbalance can lead to large swings in performance. Compare that with a fund that's price-weighted: Because there's less of a difference between the prices of various stocks than there is between the market capitalizations of companies, a price-weighted index fund will tend to be better diversified and thus a steadier overall performer.
If you think this discussion is academic, then take a look at North Track Funds' PSE Tech 100 Index (ticker PPTIX). According to Morningstar analyst Scott Cooley, this index fund is "making its actively managed rivals look silly." The fund managed to catch much of the technology-stock surge in 1998 and 1999, while posting relatively narrow losses in 2000 and much of 2001. And that was because of the way the benchmark index was constructed-with an emphasis on issue and subsector diversification.
A Different Approach To Sector Investing
PSE Tech 100 is by far the oldest of North Track's three sector-specific index funds, and the company used the lessons it learned from that fund to construct its other index offerings. When North Track launched its financial and health-care funds, the firm made diversification a priority. Take, for instance, the 4/40 rule. "Stock positions with a weighting in the index of 4% or greater can't aggregate more than 40% of the entire index," explains Chief Investment Officer Brian Andrew.
Hewing to such diversification can mean putting in some additional work. North Track chose to partner with Dow Jones to launch its health-care index-Dow Jones U.S. Health Care 100 Plus (NDJAX). The Dow Jones index had a lot of holdings, but assets were concentrated within the top names. The index also contained roughly 170 stocks, posing some practical challenges.
Working together with Dow Jones, North Track pared the original list of 170 health-care stocks to 100, while improving subsector diversification and maintaining a "near-perfect" correlation to the index. Instead of using a pure market-cap weighting for the benchmark, they use a float-adjusted market-cap weighting that basically subtracts shares owned by the company. A similar process took place with the financial-sector fund-Dow Jones U.S. Financial 100 Plus (NDUAX)-in which the original list of about 270 names was shrunk to 100. The financial and health-care index funds launched in April.
Using The Funds In A Portfolio
A larger question is why the North Track lineup currently consists of four equity index funds (the three mentioned above plus an S&P 500 index fund) and just two actively managed stock funds. According to North Track President Robert Tuszynski, the company isn't trying to do a Vanguard imitation. Rather, it's offering an alternative way for advisors to put together portfolios.
"The way we work with an advisor," explains Tuszynski, "is talking with them about the health-care, financial and technology indexes being a core investment across their entire portfolio." North Track produces research (see chart) showing that in 19 out of the past 20 years, one of those three sectors has led the market.
Andrew makes a convincing case that one or more of these sectors will continue to lead the market going forward. "One of the things that leads us to both health care and technology," he says, "is that you find that the return on research and development is higher in health care and technology than in other sectors."
Demographics favor both financials and health care. Because age and wealth tend to be positively correlated, an aging population will be more likely to invest heavily in mutual funds, purchase variable annuities, use financial advisors and so forth. An aging population also is more likely to seek medical help.
So, if past trends hold, advisors could, in theory, put together well-diversified portfolios that deliver most of the market's gains by simply buying one financial, one technology and one health-care fund. Tuszynski says advisors then could add their favorite small-cap or value funds to this large-cap, growth-oriented core.
Advisors might rightly be wary of recommending such a portfolio to their clients, given that history sometimes repeats itself and sometimes doesn't. Nonetheless, North Track's unusual sector funds provide advisors with some interesting new tools.
Olivia Barbee is the editor of MorningstarAdvisor.com. North Track Funds is a participant in the site's Due Diligence Center.