Thursday, February 15, 2007


Heresy! Apostasy! Revisionism! Doctrinal divergence! Implying an insurrection in the mutual fund industry is the equivalent of burning the American flag; slapping Mom in the face; crushing the apple pie with your foot. It desecrates everything we’ve learned about investing. What has happened to loyalty, to reverence, to respect? Ah! But you see that’s really what America is all about: progress, invention, innovation, transformation, and yes, even revolution.

If that sounds familiar, it’s because it was the opening paragraph of an article published in this column two and a half years ago, in August 2003, under the title, “The Mutual Fund Insurrection.” It referred to what was then, only through implication, the second most revolutionary structural change in the mutual fund industry that ever occurred. The first disruption was the recognition of indexing as a superior strategy to the use of actively managed funds. The second revolution referred to in the headline as a “resurrection,” was the creation of Exchange Traded Funds (ETF’s).

The article cited the existence (in August 2003) of 30 ETF’s, then marketed with about $30 billion in assets. A follow-up article in this column was published in June 2004, at which time those numbers had sharply escalated to 150 ETF’s with an asset value of $160 billion. As a clear indication of the explosion of interest in this type of investment vehicle, there now exists some 300 ETF’s with a value of over $400 billion. It is expected that 100 additional ETF’s will be offered in 2007, and Morgan Stanley expects this category to expand to $2 trillion within a few years.

For those still unfamiliar with ETF’s, they are very similar to index mutual funds in that they hold a portfolio that mimics a particular index such as the S&P 500 or the Dow Jones Industrial Average. Unlike mutual funds that are bought and sold at the day’s closing price ETF’s are traded and priced intra-day just like stocks. Whatever commission you now pay for buying and selling stocks will apply. They invariably have a much lower expense factor than actively managed funds and even most index funds. They are also more tax efficient than most index funds.

Years ago, within the advertising establishment, a common tactic employed to boost consumer interest and sales, was to repackage and remarket a product with the words, “new and improved.” As with all successful products, the entrepreneurial American spirit, rarely satisfied with the status quo, has recently intervened with several “new and improved” twists that will certainly add to the lure of the ETF concept and might be of interest to you. The publicity surrounding these innovative “improvements” has been intense. In the past several weeks, articles have appeared in Barron’s, Business Week, Forbes, most recently in U.S. News & World Report, several Internet sites, and the Wall StreetJournal describing these enhancements. In addition, a long op-ed piece appeared in the Journal written by one of the innovators, Professor Jeremy Siegel of the Wharton School of Business, and author of the seminal book, Stocks for the Long Run.

Traditional index funds as well as most existing ETF’s are structured based on “market capital weighting,” where company stocks with higher market values (the number of outstanding shares multiplied by the stock’s price) have a greater influence on the index’s performance than those with smaller valuations. That system leaves some indexes such as the S&P 500 dominated by the large cap stocks. For example, the 10 top valued stocks comprise close to 20 percent of that index.

But what if fundamental factors instead of market values were used to weight indices — factors such as dividends, sales, or earnings? Two individuals have taken the lead in developing this idea and translating it into two families of ETF’s. One is Jeremy Siegel mentioned above. The other is Robert Arnott, chairman of Research Affiliates, and editor of the Financial Analysts’ Journal. Both believe that fundamental indexing can provide better returns than those achieved by market cap weighted funds over long periods.

Sharply critical of both ETF’s and these newly formed heretical innovations, John Bogle, founder of the Vanguard Group and the creator of the first index fund based on the S&P 500 index states, “What troubles me is this talk of a new paradigm, a new wave of indexing replacing the old. It’s based on nothing but data mining.”

Be that as it may, both Siegel and Arnott agree that stocks that are overvalued are over weighted in a market-cap weighted portfolio, and stocks that are undervalued are underweighted thereby limiting optimal performance. They believe their new system rectifies this problem. There are some differences in their approach; however, both systems make for a more complicated investment process.

If you sign onto the fundamental weighting concept, decisions must be made as to which fundamental factors will produce the best returns. Siegel highly recommends dividends as the ideal solution, offering 30 different ETF’s predicated on this one factor. Some are based on large-cap, mid-cap, or small-caps; others are based on sector indices such as health and energy, while there are also international choices. Providing that many choices also sets the investor up for puzzling decisions. More information on these ETF’s including performance records can be found on Although in existence only a few months, some look pretty good.

When Arnott became disenchanted with market-cap weighted indexing, in 2003 he established an ETF that was equal weighted. It basically consists of the S&P 500 Index stocks but each is valued the same (0.20) regardless of price or market value. What gives credence to this concept is that an examination of the performance relative to the S&P 500 Index shows that this ETF, Rydex S&P Equal Weighted Index (RSP), has delivered 16.27 percent annualized returns over the past three years, compared to just 11.2 percent for the traditional S&P 500. Morningstar has just given this fund a 5 star rating. The reason for this outperformance is simple: RSP holds a significantly higher weighted proportion of small and value stocks than does the S&P 500, and they have been in favor for the past few years. That performance could switch when the trend changes.

Arnott’s new group of ETF’s that are based on a combination of sales, cash flow, book value and dividends, are offered by Power Shares under the title of Research Affiliates Fundamental Indexes (RAFI). While most are sector funds, at least two, RAFI US 1000 fund (PRF), and RAFI US 1500 Fund (PRFZ) are more diversified. They use a combination of sales, cash flow, dividends, and book value. Arnott claims that based on four decades of historical records (back testing) the RAFI 1000 fund would have outperformed the S&P 12.5 percent to 10.4 percent.

One factor that must be considered is that the expense ratio of the RAFI funds are .60 percent while the S&P ETF’s can be bought with expenses as low as .09 percent. Other critics, as described in The New York Times article, maintain that “the fundamental approach isn’t really indexing at all. After all, they contend, a fundamental index provider has to select a method for weighting stocks that it thinks is superior to the collective wisdom of the market.” Others contend that it is also a form of active management.

There is little doubt that the average investor would do better by investing in index funds than in actively managed funds. The question of which type of index funds would be best — regular mutual index fund, traditional ETF, or Fundamental ETF — is debatable. Some suggest waiting a while to determine whether fundamental indexing is truly superior.

If you want advice from the guy who is credited with creating the concept of indexing we need look no further than Burton Malkiel, the Princeton economist. It was his groundbreaking book, A Random Walk Down Wall Street, first published in 1973 that inspired John Bogle to found the Vanguard S&P 500 index Fund in 1975, the very first of its kind. An article in the January 15 th issue of U.S. News & World Report contained an interview with Professor Malkiel based on the publication of the latest update of his book (this is the ninth edition) that has sold over one million copies.

Asked what had been added in this newest edition, he replied, “The basic idea hasn’t changed. People are much better off with low-expense index funds than actively managed funds. But one of the big changes over the past several years is the proliferation of ETF’s, which are in my judgment, a fine product because they have low expenses and certain tax advantages.”

Commenting on which ETF concept he prefers, he says, “The best way to index is market-capitalization weighted [the traditional method], in which stocks are held in proportion to the total dollar value of their shares. If you use fundamental indexing or use dividends, you are taking active bets. Those active bets worked brilliantly over the first six years of the 2000’s because we were coming off a huge bubble. But I am convinced you will be much better off with capitalization weighting.”

He does offer this additional advice that can be summed up as follows:
  1. Invest in a total stock market fund (or ETF) that follows the Wilshire 5000 or the Russell 3000 rather than the S&P 500 index.

  2. Buy a world (international) fund.

  3. You should have a total bond market fund and TIPS (Treasury inflation protected securities).

  4. He says, “If you think as I do, that China is likely to be the best place to invest, try an ETF that trades under the ticker symbol FXI [iShares FTSE/Xiuhua China 25 Index Fund]. It is an index of the better Chinese companies and it’s got a low expense ratio.

(I must advise readers that I personally own shares in numbers 1, 2, and 4).

Malkiel points out that although institutional investors have about 30 percent of their money indexed, less than 10 percent of all dollars invested in stock mutual funds are in index funds. I’d bet with the institution.

I almost ended this article with that statement when it occurred to me that I was not aware what percentage of index funds was represented in my own portfolio. To insure that I was not positioning myself with a “Do as I say, not as I do” syndrome, I calculated that based on some recent purchases of additional index funds, they now represent 42 percent of the portfolio. While that does not mean it’s right for everyone, it does show, as the saying goes, “I put my money where my mouth is (or is it pen?).”


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