For years, traditional market cap-weighted index funds have been the go-to product for passive investors. Besides being inexpensive, tax-efficient, and transparent, studies show they tend to outperform their actively managed counterparts over the long term.
But over the past several years, alternative forms of indexing, such as fundamental and equal weighting, have gained momentum. These indices preserve some of the low-cost and tax benefits of conventional index funds, but by taking different security weighting approaches, they aim to correct perceived inefficiencies in traditional, market-cap indices to produce better returns.
In the roughly five years since they were introduced, alternative indices have often performed better than their cap-weighted counterparts, but experts caution that investors shouldn't be lured to a particular index style based on performance alone. With each indexing method comes unique benefits and risks. "There's no one style or construction ... that's necessarily better than the others at all times," says Tom Graves, exchange-traded fund and equity analyst at Standard and Poor's. "There are a number of different ways you can weight an index, and there are potential advantages and disadvantages to all the major categories."
U.S. News asked the experts to break down the different indexing styles to help you find the right fit for your portfolio:
Market-cap indexing. The most predominant form of indexing assigns weights according to a company's market capitalization, or the market value of their outstanding shares. That means companies with the largest market capitalizations have more of a presence in an index than companies with smaller market capitalizations.
For example, consider the weightings of the S&P 500, which includes the largest 500 U.S. companies. As the share price of computer and software giant Apple has skyrocketed over the past several years, its weight in the S&P 500 has swelled accordingly—currently, it's second only to Exxon Mobil.
The primary benefits of market cap-weighted indices are twofold, says Morningstar analyst Paul Justice. "The chief benefit of the market-cap index was that one, it was really reflective of the overall stock market, [and] two, that it minimized the turnover costs," he says. "Basically, a stock would reweight itself just as its price appreciated. You don't have to rebalance that index."
Because securities shuffle less frequently in market cap-weighted indices, less buying and selling occurs, which keeps trading costs and capital gains taxes (assessed if a security is sold at a gain) to a minimum.
While market-cap weighting is the most entrenched indexing method, critics say it can lead to wild swings and periods of boom and bust, such as what investors experienced during the 90's tech bubble or more recently, the financial sector meltdown in 2008. (Investors in funds tracking the cap-weighted S&P 500 index saw the value of their funds plummet 37 percent that year.) "They fundamentally do the wrong thing, which is let winners run until the last minute, like how they got so tech-heavy just before the dot-com crash," said David Nadig, director of research for Index Publications (which publishes the Journal of Indexes), in a recent Smart Money article.
Nevertheless, experts say market-cap weighted funds still have a place in a well-diversified portfolio. "In a momentum market, cap-weighting is going to win," says James Early, advisor of the Motley Fool Income Investor newsletter and a former hedge fund analyst. "If we are in a kind of raging bull market, you want to be in a cap-weighted [fund] because the faster-growing stuff is just going to naturally assume a larger portion of your portfolio." Ultimately, it comes down to diversification, he says, and having a spread of index funds that can perform well in all types of market climates.
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."
Funds tracking alternative indices are still in the minority, and Justice says it's going to take a while to educate investors about the nuances of these investments, especially how they impact a portfolio. In particular, investors should be aware of the potential for greater transaction costs as a result of the rebalancing alternative indices do. This also increases the potential for capital gains taxes if certain securities are sold at a profit after rebalancing. "You're going to have more transaction drag," Justice says. "You're going to pay more taxes within the strategy. Those costs are going to impact returns over longer periods of time."
Graves also says investors should take note of the sector exposure a particular indexing method produces. For instance, as of late February, consumer discretionary exposure accounted for about 11 percent of total assets for the market-cap weighted S&P 500, whereas its equal-weighted counterpart had a much heavier exposure of about 16 percent. "Look not only at what kind of individual stocks are in an ETF, but what is the concentration or weighting based on sector," he says. "You've got to think about what you're getting when you buy an equal-weighted S&P 500 versus a market cap-weighted."
Above all, investors should understand what they're buying, Justice says. "When you're looking at ETFs, you've seen a lot of innovation over the last 10 years because you have to have an index in order to make an ETF," he says. "The concept of an index has really changed. Now you've created so many indexes it gets to the point these aren't things to measure the market anymore."