Index Funds That Go Outside the Box

There’s more than one way to use an index.

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Most investors think of index funds as the relatively straightforward business of structuring a portfolio to mimic the components of some benchmark, say the Nasdaq 100. If Apple represents 10 percent of the index, it should represent 10 percent of the indexed portfolio. Except for occasional rebalancing as stock values change over time, there's supposedly not much to indexing beyond establishing the proper weightings and settling in for the ride.

Turns out, there's more to indexing than simple index duplication. There are funds that use indexes in ways other than the conventional "capitalization weighting" we all know and love. Whether these are still properly considered "index" funds, though, is another question.

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Cap-weighted portfolio construction bases the size of holdings on their relative market value. The theory is that the wisdom of crowds generally gets prices "right," so a portfolio based on the market's constantly evolving verdicts will give the optimum weighting to the stocks it holds. The Nasdaq 100 is cap-weighted, as is the S&P 500. The Dow Jones Industrial Average, by contrast, is price-weighted.

A good example of cap-weighted index funds: the Vanguard 500 (symbol: VFINX), which mimics the S&P 500. That means big international names like Apple and ExxonMobil have large weightings (4.4 and 3.2 percent, respectively).

For some, that's a problem. Cap-weighting, critics say, tends toward a perverse outcome, overweighting overvalued stocks and underweighting undervalued stocks. It also gives disproportionate influence to a small handful of companies ("concentration risk"), arguably violating the time-honored spirit of diversification. Cap-weighting can duplicate the return of an index, but if you want to do better, you need a different methodology.

One alternative is the "fundamentals-based" method, which weights holdings by such things as sales, cash flow, and dividends—the basic indicators of a company's health. This method makes an implicit bet on which stocks will do better than others. Indeed, some argue that it's not indexing at all, just asset allocation with a new label. (Morningstar calls it an "enhanced value strategy.")

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Perhaps the best example of a fundamentals-based index fund is the oldest, the PowerShares FTSE RAFI US 1000 ETF (PRF). Launched in 2005 using a fundamentals approach developed by Robert Arnott, founder of investment-management firm Research Affiliates LLC, PRF now has $1.4 billion under management and has spawned a family of fundamentals-based PowerShares ETFs. Morningstar calls PRF "the best of its kind." The fund's reference index comprises the 1,000 largest stocks by fundamental value as defined by Research Affiliates and the FTSE Group, a UK-based index provider.

The fund's reference index comprises the 1,000 largest stocks by fundamental value, as calculated by Research Affiliates and index-provider FTSE Group using cash flow, sales, dividends, and book value to arrive at a "fundamental weight." According to Morningstar, the calculation excludes dividends for companies that have never paid one, and it uses five-year averages for each measure except book value.

The whole approach, says Morningstar, creates a bias toward value stocks. That's consistent with a common criticism of fundamentals indexing, namely that it under-emphasizes growth stocks, which early on can report meager earnings, and over-emphasizes value stocks.

Yet a third approach is called "equal weighting," which simply takes the constituents of an index and gives them equal representation in a portfolio. In an equally weighted S&P 500 portfolio, each stock would represent 0.2 percent of the total, and the index's top-10 holdings would represent 2 percent of the portfolio instead of the 20 percent they represent in the actual S&P. One prominent example: the Guggenheim (formerly Rydex) S&P 500 Equal Weight ETF (RSP), with $2.8 billion under management.