Alternative indexing. These indices come in two main varieties: equally weighted and fundamentally weighted. As its name suggests, the equal-weighted approach portions out index weights equally so that individual large-cap stocks have just as much weight as individual mid- or small-cap stocks. For example, each holding in Rydex's S&P Equal Weight ETF (symbol RSP), which tracks the S&P 500 index, has a 0.2 percent weight (or 1/500th) in the portfolio. Fundamentally weighted indices weight securities based on specific business metrics or a combination of business metrics, such as revenue, dividends, earnings, sales, or cash flow. For example, fundamental ETF firm RevenueShares weights on revenue, while another, WisdomTree, weights on dividends and earnings. (For a more detailed explanation of how fundamental indices work, see Fundamental ETFs Go Beyond Index Investing.)
Alternative weighting schemes aim to capitalize on short-term inefficiencies in how the market prices stocks by rebalancing holdings quarterly or annually to account for short-term changes in the market. "Stock prices are driven by people's emotions [and] they move more than the intrinsic values. Stock prices are more volatile than the fundamentals that determine the intrinsic value of a company," says Chris Brightman, director of strategy at fundamental index provider Research Affiliates. "Markets are not perfectly efficient, there is noise in prices. [Stock prices] tend to move away from those intrinsic values and subsequently revert back. It creates the opportunity for a rebalancing return."
How do these methods stack up to traditional cap-weighted approaches performance-wise? Roughly five years after their inception, alternative indices have beaten their cap-weighted counterparts in many cases. According to Morningstar, as of March 1, the equal-weighted Rydex fund's trailing five-year returns clocked in at about 4 percent, outperforming the S&P 500 by about 1.6 percentage points. PowerShares FTSE RAFI US 1000 (PRF), which tracks the largest 1000 companies weighted by a combination of fundamentals including cash flow and dividends, returned about 4.3 percent over the past five years, compared with a 2.6 percent return for the Russell 1000.
However, because the group has a relatively short track record, many experts have reservations about depending on that kind of performance going forward. "They've been performing differently, just like we would expect them to," Justice says. "We've seen the data, we just haven't seen it applied in a broad way to say that this is something that's really going to work. You look back on market cap-weighted indices, they go back to the early 1900s and you can clearly see that stocks are a pretty good investment."
Critics of alternative indexing claim the approaches give preference to smaller-cap companies and value-style investing. "It's a complete apples-to-oranges comparison," says Joel Dickson, a principal in the investment strategy group at Vanguard. "The equal weight, for example, has a much larger factor exposure to small caps and as such, when small caps outperform, the equal-weighted [index] is going to do better than the cap-weighted. But is it because of the equal weighting? No, it's because the small caps outperformed."
Dickson also says that many times, investors can achieve the same performance and exposure to small caps using conventional, often less expensive, market-cap weighted index funds. "To the extent that you're trying to target different factor exposures than the broad market, you can do that with existing market cap-weighted indexes," he says. "If you want small-cap exposure, invest in a small-cap fund. You can then essentially replicate the factor exposure."