Although every investor wants to beat the market, few are able
to do it consistently. But what if, over time, you could beat the
broad market with something as simple as an index fund?
Some exchange-traded funds--members of a new class of ETFs--have
done just that. They are called fundamental-index funds because
they focus on companies' financial results, such as sales or
earnings, not just their size. PowerShares FTSE RAFI US 1000 ETF
), for example, leans toward large U.S. firms with strong balance
sheets. Over the past five years, it has returned 18.8% annualized,
beating SPDR S&P 500 ETF (
), a traditional index ETF that tracks Standard & Poor's
500-stock index, by an average of 3.6 percentage points per year
(all returns are through November 1).
Eager to jump in? Not so fast. These newfangled designer index
funds offer fresh, sometimes compelling strategies, but they are
not magic. For starters, their strategies can take ten years or
more to play out. Plus, each index is unique, so it's important to
understand how they are built and any extraordinary risks they pose
before you incorporate one into your portfolio.
What are fundamental-index funds?
Instead of weighting stocks by market capitalization, the way
traditional indexes do, fundamental indexes use measures that are
tied to a company's financial picture, such as earnings or
dividends, to name a few. A few of these funds are a decade
old--among them, iShares Select Dividend (
), which sifts stocks for those with high dividend yields and ranks
them by their yield. But many are much newer. Of the nearly 220
fundamentally oriented ETFs, nearly half have been around for five
years or more. Nevertheless, investors are buying. The funds now
hold more than $1 trillion in total assets.
The draw: Over the long haul, fundamental-index funds will beat
the market. At least, that's what the firms behind these funds will
tell you, based on extensive back-testing that pitted many of the
new indexes against the best-known market-cap-weighted benchmarks,
such as the S&P and Russell indexes. "Fundamental indexes have
outpaced by two percentage points per year" over long periods, says
Chris Brightman, of Research Affiliates, a Newport Beach, Cal.,
pioneer in fundamental indexes.
But back-testing is one thing. How have these ETFs performed in
real life? The answer is mixed. Among those with a five-year record
(more than 80 funds), half beat the typical fund in their
respective category and the other half lagged.
From its launch in December 2006 through November 2013,
PowerShares Fundamental Pure Small Core (
) has lagged the small-company Russell 2000 index. The fund has
tracked two different fundamentally oriented indexes. From
inception through June 2011, PXSC tracked an Intellidex index that
considers factors such as a stock's price relative to its 52-week
high, cash flow, book value, and share buybacks, among others. Over
that time, the fund lost an annualized 1.6%, lagging the Russell
2000 by an average of 2.9 percentage points per year. In mid-2011,
the fund adopted a RAFI fundamental index that focuses on sales,
dividends, cash flow and book value. But the change has not helped
much: The fund has continued to lag; from the time the switch was
made through November 29, it trailed the Russell 2000 by an average
of 1.5 percentage points per year.
The bottom line: Not all fundamental indexes shine. And although
some are better than others, the higher returns may come with more
risk. Many of these funds plunged more than the overall market in
2008, for instance, though they rebounded strongly in 2009. That
combination suggests that some fundamental-index funds are more
volatile than their vanilla rivals. PowerShares FTSE RAFI US 1000,
for instance, lost 40.0% in 2008--3.0 percentage points more than
the S&P 500 lost--and ranked among the bottom 10% of all ETFs
that focus on large, undervalued companies. But in 2009 it beat its
benchmark by a staggering 15.2 percentage points, with a 41.7%
return. Over the past five years, the FTSE RAFI US 1000 ETF has
been 22% more volatile than the S&P 500 and funds that track
Time--as in decades--will tell whether enhanced index funds are
better than funds weighted by market capitalization. But for now
it's safe to say that fundamental-index funds are just different.
"It's all salad, just a different dressing," says Rick Ferri,
founder of Portfolio Solutions, a Troy, Mich., investment firm that
uses index funds and ETFs.
How do they work?
Some funds home in on a single factor, such as revenues,
earnings or dividends, and use it to drive stock selection and
weighting in the index. In WisdomTree's profits-focused index
funds, such as SmallCap Earnings (
), a firm's profits count for more than its market value in
determining its rank in the fund. WisdomTree's dividend-focused
funds, on the other hand, put the emphasis on--you guessed
it--dividends. And in the ETFs from RevenueShares, only sales
Others focus on a combination of measures. RAFI indexes, created
by Research Affiliates, weight firms by sales, dividends, cash flow
and book value (assets minus liabilities). First Trust employs
three value-oriented and three growth-oriented factors to create
its AlphaDex indexes, including return on assets on the value side
and sales growth on the growth side.
Another key difference between these index funds and their
traditional counterparts: regular rebalancing. Some
fundamental-index funds do it quarterly (RevenueShares); others do
it once a year (some WisdomTree and iShares funds, for example).
Market-cap-weighted index funds, by contrast, are never rebalanced.
All the extra work required is one reason fundamental-index funds
cost more. They charge an average of 0.55% in annual fees--more
than the typical charge of 0.48% for traditional index funds.
Should I invest in a fundamental index?
Don't replace all of your traditional index funds with
fundamental-index products. Instead, use them to further diversify
your portfolio. Some advisers who use funds suggest that clients
split their index money 50-50 between traditional and
fundamental-index funds (on top of any assets you may have in
actively managed funds). Anthony Davidow, an asset allocation
strategist at Schwab, prefers a 60%-40% mix of fundamental and
traditional index funds.
Which fundamental-index funds are worth investing in?
We favor funds with easy-to-understand strategies, five-year
track records that beat the appropriate benchmark on a
risk-adjusted basis, and at least $150 million in assets. Here are
RevenueShares Large Cap (
). It's simple, and it works. This fund ranks the companies in the
S&P 500 by annual revenues over the previous 12 months. Firms
with the highest revenues get top billing. RWL has outpaced the
S&P 500 over the past five years by an average of 2.4
percentage points per year. What's more, the fund has been only
slightly more volatile than the S&P 500.
WisdomTree MidCap Earnings (
). Annual earnings determine the ranking in this fund. Over the
past five years, its 23.2% annualized return beat iShares Russell
Mid-Cap ETF (
) by an average of 3.8 percentage points per year.
Wisdomtree International SmallCap Dividend (
) has been a bit less volatile than SPDR S&P International
Small Cap ETF (
). But the WisdomTree fund has outpaced GWX over the past five
years by an average of 1.7 percentage points per year. And
WisdomTree Emerging Markets SmallCap Dividend (
) has been less volatile than SPDR S&P Emerging Markets Small
Cap ETF (
), yet it has beaten the SPDR ETF by an average of 1.7 points per
year over the past five years.