GUEST AUTHOR BLOG by Sheldon Jacobs author of "Investing Without Wall Street: The Five Essentials of Financial Freedom."
There are several ways to construct a stock market index.
The most common way is to weight (that is to say determine its importance) the stocks in an index by market capitalization.
This method weights each stock in a portfolio based on that company’s market capitalization, which is simply the price of the stock times the number of shares outstanding.
The bigger a company’s market cap, the more it counts in the index. The S&P 500, DJ Wilshire 5000and Russell 3000are all capitalization weighted indexes.
However there are problems with capitalization weighting.
A high weighting doesn’t necessarily indicate a more profitable company or even necessarily a larger company by other measures. A company can have a big market cap simply because investors, enamored with the company, have rightly or wrongly driven up its price. Remember, price is the dynamic part of the formula. The other part of the formula, the number of shares outstanding, changes very little.
Cap-weighting worked far better in the ‘90s than in the 2000s because it suffers from an inherent flaw. With price the major variable factor in the index’s construction, cap-weighting tends to overweight overvalued stocks and underweight undervalued stocks, particularly in bull markets. In many cases, the reverse would be better.
The reason cap-weighting worked so well in the ‘90s was that overvalued stocks, especially Internet stocks, tended to get even more overvalued, as crazed investors kept bidding up the price regardless of true value.
Until they didn’t. Needless to say those days are long gone.
The Fundamental Indexing Alternative
As a result of these deficiencies, there is now another way to index stocks. It’s called fundamental indexing. The idea behind it is to weight an index by using the true fundamental measures of each company’s worth. Research Affiliates, a Pasadena, California institutional money manger, which developed the index, employs four specific metrics in constructing a fundamental index. They are book value, cash flow, sales and dividends. By taking price out of the weighting formula, fundamental weighting reduces the influence of manias, bubbles, and overreactions to good or bad news.
"I prefer fundamental weighting. I think it’s safer and will perform as well as or better than traditional index funds in the long run."
With fundamental weighting, price changes do not directly affect the weighting. Overvalued stocks don’t get a higher weighting, nor do undervalued stocks a lower one. Significantly, neither cap-weighting nor fundamental weighting indexing involves any security analysis.
Which Is Best Over the Long Run?
Evidence is building that these fundamental funds will out perform cap-weighted index funds over the long haul (but not necessarily in any given year). Take two typical broad-based index funds. The fundamentally weighted fund is Power Shares FTSE RAFI US 1000 . It averaged 15.9 percent annually for three years ending this May. The cap-weighted alternative, Spiders that invests in the S&P 500 , averaged 14.7 percent, or eight percent less. Measured over five years, PRFs advantage was greater (-0.7% vs. -1.0%) but perhaps not as meaningful.
Then there is the risk difference. Currently, the largest stock in the S&P 500 is Apple. It’s weighted at 4.5% of the index. In PRF, Apple is just the 24th largest holding with a 0.6% weighting.
How risky is Apple? Risk is hard to quantify, but Apple’s shares recently closed at $580, up 43 percent since January 1 and up 53 percent since Steve Jobs died. And that’s after selling off nine percent from its recent high of $644. Obviously bad news has the potential to knock down Apple’s price.
I prefer fundamental weighting. I think it’s safer and will perform as well as or better than traditional index funds in the long run.
Some Fundamental Index Fund Choices
There are three investment firms now offering fundamental weighted indexes.
PowerShares Capital Management, an investment advisory firm now owned by Invesco, manages 90 ETFs, is using Research Affiliates’ methodology. Two of its ETFs to consider are PowerShares FTSE RAFI US 1000, which owns approximately 1,000 stocks, and PowerShares FTSE RAFI US 1500 Small-Mid portfolio .
Another company is Wisdom Tree, which manages ETFs, but weights on dividends only, and the third is Charles Schwab, which sponsors fundamentally weighted index funds using the Research Affiliates criteria.
I would recommend a 50-50-split between-cap weighted and fundamentally weighted index funds for your own portfolios.
Sheldon Jacobs is the author of the first ever self-help book on no-load mutual funds, Put Money in Your Pocket. In 1979, he founded the popular investment newsletter The No-Load Fund Investor, which went on to become the number one financial newsletter in America for risk-adjusted performance for a fifteen year period ending in 2006, and for which he is now a contributing editor. Mr. Jacobs is a member of Bottom Line/Personal's investment advisory panel, was a founding advisor to Charles Schwab's Financial Advisory Service Board, and has been listed in Who's Who in America. His newest book, "Investing Without Wall Street: The Five Essentials of Financial Freedom," is on sale now.