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Skarbeck: A new type of index fund is gaining investor interest

September 20, 2014

Ken SkarbeckPreviously, we discussed how index funds provide an investor a low-cost means to earn the stock market rate of return, which financial academics call “beta.” Index funds have proved to be an attractive investment option.

Yet even these plain vanilla index funds have recently been subject to criticism in academic circles. The complaint is that popular index funds, like those that track the Standard & Poor’s 500 index, are “market-capitalization weighted,” meaning the largest companies in the index contribute far more to the overall performance of the index than the smaller companies.

As noted in my last column, the top 10 stocks in the S&P 500, or just 2 percent by number, determine 17.8 percent of the S&P 500 index performance because of their size. Critics argue that size-weighted indexes are a form of momentum investing and that you end up overpaying for the stocks that have performed well.

Recently, financial academics, like Rob Arnott of Research Affiliates, have published white papers supporting a different type of index investing. They call their creation “smart beta.” Smart beta indexing claims to improve on the standard index fund by adding some fundamental criteria to the construction of an index fund to improve its performance.

For example, one simple change would be to weight each stock in the S&P 500 equally. In other words, Apple Computer on down to Dun and Bradstreet each would contribute 0.2 percent, one-500th, to the overall performance of this new “equally weighted” index fund. That compares to Apple’s current 3.5-percent weight and Dun and Bradstreet’s 0.02-percent weight in a standard S&P 500 index fund.

Right away, we see that in the equally weighted index fund, smaller stocks and stocks that have not risen as much as Apple will have much more of an influence on the index performance. Observers have described these as “value-oriented” index funds, because small and undervalued stocks will contribute more to overall performance.

Arnott recently defined smart beta as “a category of valuation-indifferent strategies that consciously and deliberately break the link between the price of an asset and its weight in the portfolio, seeking to earn excess returns over the cap-weighted benchmark by no longer weighting assets proportional to their popularity.”

Arnott’s firm has been successful with its proprietary RAFI index fund with a value and small-cap tilt that also purports to increase the allocation toward value stocks when they are out of favor. His firm has attracted $140 billion in indexed assets over the past 10 years.

Wall Street has jumped on the trend, sensing new product sales. According to Morningstar, there are 367 smart beta ETFs holding $346 billion in assets. Institutions are piling into smart beta, with one survey showing 42 percent of institutions planning to make allocations to smart beta strategies.

Regardless, smart beta is still controversial. Investors would be better served ignoring the hype behind a smart beta label and recognize these funds at times make good investments. Particularly when stocks are cheap and out of favor.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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