A comparison of the Rydex S&P Equal Weight and PowerShares FTSE RAFI U.S. 1000 Portfolio to corresponding market-cap-weighted index products illustrates the pros and cons of each approach. Over the five years ending December 31, 2010, the Rydex fund had an average annualized return of 4.16%, compared to 2.28% for the SPDR S&P 500 ETF (SPY). Rydex held the edge largely because of its greater emphasis on smaller companies and sectors with a large number of small constituents, such as consumer discretionary.
Over the same period, the PowerShares offering had an annualized return of 4.27%, compared to 2.54% for the market-cap-weighted iShares Russell 1000 Index ETF (IWB). In this case, the alternative index ETF benefited from a tilt toward value and smaller companies.
However, both PowerShares FTSE 1000 and Rydex S&P Equal Weight underperformed their market-cap-weighted counterparts in the downturn of 2008. And in a market that favors large-cap or growth stocks, the market-cap-weighted ETFs would likely outperform.
"Enhanced or fundamentally weighted indexes seek to outperform the market," notes Morningstar analyst Michael Rawson. "But to do this requires risk-taking and the ability to endure periods of underperformance."
One area where market-cap-weighted indexes win hands down is cost. While market-cap-weighted fund expenses range from 0.06% to 0.28%, the alternative offerings clock in with expenses of 0.23% to 0.88%.
Tax efficiency is another issue. Because alternative index ETFs need more frequent rebalancing to follow their strategies than their market-cap-weighted counterparts, their turnover rates of 15% to 30% are somewhat higher than the 3% to 15% annualized turnover for market-cap-weighted ETFs. That's still well below the turnover rates of 100% or more for actively managed funds. So far, at least, the tax-efficient ETF structure has made it possible for the alternative funds to avoid paying out significant capital gains, says Matt Hougan, president of analytics for exchange-traded funds at IndexUniverse.
Advisors who have migrated into the new indexes say they are pleased with them thus far. And they are finding their own unique ways to use them.
Christian Wagner, chief executive officer at Longview Capital Management in Wilmington, Del., began using an equal-weight S&P 500 ETF as a core position in April 2009. As the market began pulling up, he reasoned, the small-cap and mid-cap bias in the equal-weight ETF would put it in a better position to outperform, which proved to be the case.
He hasn't abandoned market cap weighting, though, and would consider switching back if he sees clear evidence that mega-caps are taking a strong lead. "I see the market-cap-weighted ETF as a more defensive position that would be appropriate in the more mature cycle of the market," he says. "The decision to shift between traditional and alternatives indexes is really driven by where we are in the market cycle and where we see relative strength."
Morristown, N.J.-based RegentAtlantic Capital, which manages over $2 billion in assets, has used fundamental index products for its large-cap U.S. and international allocations for over two years, according to Brian Kazanchy, who chairs the firm's investment committee. He believes that weighting stocks based on their fundamental values simply makes more sense than giving a stock more space just because its price has gone up, and he says the strategy has successfully added alpha to client portfolios.