Investors who are using exchange traded funds that track market-capitalization-weighted indices could be missing out as more fund sponsors engineer ETFs based on “enhanced,” “smart-beta” or “intelligent” indices that mimic actively managed strategies.
According to Cass Business School, returns of traditional, market-capitalization-weighted indices are lagging behind so-called alternative indices by as much as 2% a year over time, reports Andrew Blackman for the Wall Street Journal.
Nevertheless, the market-cap-weighted approach also has its benefits, and investors should consider the merits of every indexing methodology.
“We’re not here to bury cap-weighted indexing as an approach,” John Belgrove, senior partner at consulting firm Aon PLC unit that sponsored the research, said in the article. “It has a lot of advantages, especially around transparency. But we want investors to be conscious that it’s a choice, and there are other choices available.”
Critics of market-capitalization weighted indices argue that the methodology leaves an index’s overall value vulnerable to reversals in a few big stocks that have registered significant gains.
In contrast, the alternative indexing methodologies lean toward small-cap and value-oriented stocks, or both. Consequently, these types of stocks consistently outperform large-cap stocks and so-called growth stocks in rapidly expanding companies – this phenomena is also known as the Fama-French model.
Alternative indexing methodologies have been gaining momentum. Over the first five months of 2013, U.S.-listed ETFs that track alternative indices have gathered 43% of new net inflows, compared to 20% for all new inflows last year.
The two most common alternative indexing styles revolve around equal-weight and fundamental strategies. Equal-weight indices would simply allocate an equal share of the index to each component stock. A fundamental index uses “fundamental” value figures such as sales, earnings, book value, dividends or cash flow to select component stocks. However, the strategies may be slightly more expense than traditional market-cap index ETFs.
For instance, the Gugenheim S&P 500 Equal Weight ETF (NYSEArca: RSP) has a 0.40% expense ratio, compared to the SPDR S&P 500 (NYSEArca: SPY) with a 0.09% expense ratio. RSP has consistently outperformed SPY over the past 10 years, generating an average 9.7% over the past decade, compared to the 7.3% return of SPY. [‘Enhanced’ Index ETFs That Are Outperforming the S&P 500]
Additionally, the PowerShares FTSE RAFI U.S. 1000 (NYSEArca: PRF), a fundamentally weighted index of the largest U.S. companies, has generated an average 11.0% over the past five years, compared to the 7.1% gain in the iShares Russell 1000 Value Index (NYSEArca: IWD).
For more information on ETFs and indexing, visit our indexing category.
Max Chen contributed to this article.