A new Standard & Poors report shows that from 2002 to 2007 the S&P 500 beat 72.2 percent of all active large-cap funds surveyed. This underperformance of active managers is increasing the popularity of exchange-traded funds. A recent report by Tabb Group Research estimates that active fund managers could lose as much as $12 billion a year in potential management fees from the move to exchange-traded index funds. At the end of 2007 the global ETF market was worth close to $800 billion, a rise of around 41 percent on the previous year; Morgan Stanley estimates that global ETF assets under management will exceed $2 trillion by 2011.
However, while passive investing can be more successful than the average active manager, this basic "buy the index" approach has inherent weaknesses.
Most index investors use traditional tracker funds based on well known cap weighted indexes, such as the S&P 500. If a particular market is not "informationally efficient" - i.e. the price of a stock does not reflect all known information about an enterprise and does not suffer from irrational behavior, then weighting by market capitalization would be optimal.
However, we all know stock prices are influenced by short-term factors that may have little to do with underlying fundamentals. Stock prices are also influenced by short-term momentum trading or mergers and acquisitions speculation. Many hedge funds make their money looking for arbitrage opportunities that exploit these inefficiencies.
But over the long-term, does market cap give you the best prospect for long term investment growth? By definition, market-cap weighted indexes do the opposite of the basic buy low/sell high formula. They have to add more stock as the price increases and less as the price decreases. Market capitalization must do this in order to help keep the price-weight link intact.
So what should investors do to beat the index? Investors looking for alpha have traditionally avoided index investing as, by definition, they want to beat their benchmark. However, the index investing industry has evolved. Now there are indexes that offer a fundamental approach to beating the benchmark.
Within a fundamental index, companies are selected using 'fundamental' criteria, such as profitability, cash flow or growth, which are strong indicators of a company's current prospects to compile an index of stocks with high performance potential. Academic research indicates that fundamentally-based indexes outperform market cap-weighted indexes. For example, when Arnott, Hsu and Moore constructed a 1,000 stock portfolio based on cash flow, sales dividends and book value parameters, and the portfolio's performance was back-tested from 1962-2004 against the S&P 500, the results showed an excess in performance of 2 percent, a superior Sharpe ratio (0.45 vs. 0.30 for S&P 500) and significant out performance of the benchmark index in a bear market.
These new fundamental indexes have set the scene for more sophisticated ways of using fundamental analysis to create model stock portfolios. Stock research companies, such as MarketGrader in Miami, have combined the principles of index investing and effective portfolio construction to create model portfolios of fundamentally attractive stocks.
These indexes work by analyzing a wide universe of stocks on the strength of their fundamentals to award each stock a rating. Selections then are created by selecting the top-rated stocks, subject to rules designed to ensure sensible portfolio diversification, such as sector and size limits.
Market cap-based standard indexes already have proved their popularity, particularly with institutional investors, but fundamental indexes are well positioned to be even more popular in the long-term as investors grow more and more disillusioned with the potential under-performance of active mutual funds.
Daniel Freedman is managing director of SPA Exchange Traded Funds, a family of fundamentally based, equally weighted equity ETF.