Most beta index exchange traded funds follow a market-capitalization weighted methodology, but with the expansion of the fund universe, investors are beginning to take an interest in alternative indexing styles.
According to EDHEC-Risk Institute, a recent survey of institutional investors revealed that over 50% of respondents see cap-weighted indices as “problematic” and 40% of investors have adopted alternative indexing schemes, writes Virginia Munger Kahn for Financial Advisor.
Market capitalization-weighted indices dominate the ETF space, with only 8% of U.S. and international stock ETF assets following alternative indices.
Nevertheless, alternative indices, including “enhanced,” “smart” or “intelligent” indices, are gaining traction, such as the fundamental indexing methodologies.
Fundamental indexing styles provided by Research Affiliates, WisdomTree and others, try to weight stocks on factors like dividends, earnings, cash flow, sales and book value. Consequently, the indices are heavier on value and small-cap stocks. Investors should be aware that these indices rebalance more ferequently, which may lead to higher turnovers and higher costs.
“We’re seeing phenomenal growth in fundamental index strategies,” Shane Shepherd, senior vice president and head of fixed income research at Research Affiliates, said in the article.
Critics of the market-cap methodology argue that the indices lean toward increasingly more expensive stocks as the market capitalization distends.
On a performance basis, Research Affiliates calculated that from 1962 through 2012, the annaul return of the Research Affiliates Fundamental Index Composite outperformed the S&P 500 by 2.1% per year. [A Fundamentally Weighted ETF That’s Beating the Market]
“We don’t believe the markets are perfectly efficient,” Shepherd said. “A fundamental system, with regular rebalancing, is a great way to take advantage of those inefficiencies.”
For more information on indexing in ETFs, visit our indexing category.
Max Chen contributed to this article.