From the January 2012 issue of Research Magazine • Subscribe!

Do Indexes Matter?

One of the driving forces behind the exploding number of new exchange-traded products (ETPs) is the exploding number of new indexes. And since the bulk of the $1.1 trillion ETP marketplace is still linked to products with underlying indexes, advisors better know their indexes. Do you go with a traditional or fundamental index? Let’s examine this and related questions, and start with some history.

The idea of market indexes dates back to the late 1800s when Charles Dow introduced the Dow Jones Transportation Average (DJTA). Dow calculated the indicator’s value by adding up the closing price of the 11 leading transportation stocks. He used this same calculation method for other barometers, like the Dow Jones Industrial Average (DJIA), which is a collection of 30 blue chip stocks.

Dow’s method is still used today for calculating the DJTA and DJIA and reflects the price of stocks rather than the value of the companies. For instance, a company with a tiny market value could have a $90 stock price while a larger company within the same barometer could have a $9 stock price — yet the smaller company would count 10 times more in the DJTA or DJIA versus the larger company. 

Amid recognition of the shortcomings of stock price weighted indicators, value weighted methods began to take hold during the 1950s. A value weighted index calculates the price of each security and multiplies it by the number of shares outstanding.

“This method provides a general price track as well as a valuation yardstick for the wealth of the market or a segment of the market,” explains Richard A. Ferri, in his book titled The ETF Book (Wiley, 2009). “Value weighted indexes are the standard for the measurement of market values around the world.”

Indexing 2.0

While the original thought of benchmark indexes was to provide a way to measure the market’s performance, indexes with alternative weighting schemes were introduced in the late 20th century.

Among this group are equal weighted indexes, which use a simple calculation method by giving each security the same level of representation within the index. This prevents any single security from dominating the overall benchmark’s performance.

In the late 1990s, the idea of “fundamentally weighted” indexes was born. Instead of weighting stocks by their market size or their price, companies were weighted by key financial metrics like book value, dividends, sales, and profitability. Instead of serving as mere yardsticks of the market, the chief aim of this new generation of indexes was to launch investment products like ETFs, in order to give investors building blocks for their portfolios.

Fundamental Issues

The debate between traditionalists, who believe in market cap weighted indexing, and fundamentalists, who don’t, is similar to the perpetual disagreement between Yankee and Red Sox fans about which city has the better baseball team. Depending on the historical time period one examines, one group is right and the other is wrong. And during some periods, both groups can make a strong case.

Even within the fundamental camp there are disagreements about which financial factors produce optimal long-term investment returns.

WisdomTree’s stock ETFs are built around earnings and dividends as their principal weighting factors. On the other hand, the Invesco PowerShares FTSE RAFI indexes use a combination of four fundamental factors, including book value, cash flow, sales and dividends. Each company is selected and weighted within the FTSE RAFI index according to how it produces in each of these four areas.

The table nearby compares the three and five-year performance history of several PowerShares FTSE RAFI ETFs versus their ETF peers that utilize a traditional market cap weighting method. In each category but emerging markets, fundamental indexes recorded a performance advantage. This advantage is most noticeable with the mid and small cap U.S. stock category. Over the past three years, the PowerShares PowerShares FTSE RAFI 1500 Small-Mid ETF (PRFZ) outperformed its competitor, the iShares Russell 2000 ETF (IWM) by a significant margin of 7.86 percentage points.

Still, it’s important that financial advisors curb their enthusiasm before telling clients they’ve just discovered the Holy Grail of investing.

It’s important to remember that the actual performance history for fundamentally weighted ETFs is limited, so it’s premature to crown them as winners. And while the past few years have certainly been a great testing ground of market extremes, they are hardly a map of how the future will turn out for fundamentally weighted ETFs.

Indexes Can Change

Advisors typically will choose an index ETF or a combination of them, in order to minimize the need for constant monitoring, which is a definite requirement when recommending investments that have a portfolio manager. But the same revolving door that money managers frequently go through also at times spins for ETFs.

Even with ETFs, advisors need to stay on top of index changes that often occur subtly and without fanfare.

In October, State Street Global Advisors swapped the underlying indexes for five of its financial ETFs from Keefe, Bruyette, and Woods to Standard & Poor’s. Meanwhile, the KBW financial indexes dropped by State Street were adopted by Invesco PowerShares for four ETFs.

The difference between the strategies behind the new financial SPDR ETFs linked to S&P indexes versus the old ones linked to KBW benchmarks is bigger than it appears. The S&P financial indexes equally weight financial stocks whereas the indexes managed by KBW use a market cap weighting method. This change forced the SPDR S&P Bank ETF (KBE) to immediately cut its exposure to large bank stocks like Bank of America and Wells Fargo.

Unfortunately, changes to index providers and indexing strategies are occurring with more frequency. Over the past two years alone, almost 80 ETFs have changed their indexes. No wonder so many advisors are opting to put their clients in ETFs linked to prominent indexes that have stood the test of time.

How can advisors avoid indexing gimmickry and stick with index ETFs that serve a useful purpose?

“I think it’s a very difficult task to do with the plethora of ETF products and strategies,” said Walter Pachniuk, CFP at The Advisers Trust in Newtown, Conn. “I’ve restrained myself with my investment model that I’ve had in place for 20 years. We use low cost active managers with another portion in low cost ETFs or mutual funds that cover the various asset classes.”

Here’s another tip: When examining the performance and expenses for ETFs following divergent weighting methods, like equal or fundamental, advisors should evaluate the data versus both traditional index ETFs and actively managed mutual funds.

Some advisors have found fundamentally weighted ETFs to be a lower cost and more tax efficient alternative to active mutual funds. Others who aren’t sure which indexing camp to join are hedging their clients’ risks by using a combination of fundamental and traditional index ETFs.

In summary, the indexes behind the ETFs you select for client portfolios do matter. Be educated and choose wisely! •

Reprints Discuss this story
This is where the comments go.