Plain or turbocharged?

18Dec05

Do you want your index funds plain vanilla or turbocharged? Two articles examine the way that index funds are created and marketed.

Jack Egan in the New York Times covers the recent phenomena of “designer index funds.” These funds attempt to outperform standard capitalization-weighted index funds through overweighting certain types of securities in an attempt to created index funds that have better returns.

The article focuses on PowerShares Capital Management and the various methods and indices they use to create proprietary exchange traded funds (ETFs). However the competition in the ETF arena is growing. WisdomTree Investments, which is backed by a bevy of financial heavyweights, is expected to enter the ETF marketplace in the very near future. Their strategy according to Jeremy J. Siegel of Wharton, includes, “designing enhanced-index products that we feel are superior to what’s out there now.”

Some in the investment industry are skeptical that there are “free lunches” out there that allow enhanced-indexers to generate systematically higher returns with lower risk. Indeed this new funds are taking active bets, that while they have paid off in the past, may not continue in the future. Despite these complaints:

Some critics say they still think that the new designer index funds are useful. “Though I’m skeptical, this kind of innovation is appealing,” said Jim Wiandt, editor of the Journal of Indexes and publisher of IndexUniverse.com. “It keeps indexers on their toes and makes sure the indexes are running as efficiently as possible.”

In a similar vein, Mr. Schoenfeld said: “These are interesting innovative products that can potentially play a role in a portfolio. But they are not a substitute for indexing itself – the starting point has to be indexing at the core.”

Jonathan Clements in the Wall Street Journal notes that index funds based on the plain, old Standard & Poor’s 500 have done their job. These funds continue to outpace the majority of active fund managers. However, it is really a historical fluke that this particular index became the basis for the indexing industry.

Clements wonders if there is a better tool available for investors. Clements notes that the S&P 500 ignores smaller capitalization stocks and international stocks. In addition, the index is not ideal in terms of tax-efficiency. As a modern alternative Clements finds a still simple solution.

My contention: There should be two new kings of indexing. Indeed, I believe anybody building a stock portfolio should start with two index funds: a U.S. total-market fund and a broadly diversified foreign-stock fund…

To build a globally diversified stock portfolio, put 70% of your stock portfolio in the total-market fund and 30% in the foreign-stock fund. What if you are a little more adventurous? You could use these two funds as your core holdings, but slice off a few dollars and invest them in more specialized index funds.

We noted earlier that at some point the market for index-like exchange traded funds will become saturated. Given the likely flow of new ETFs, that day is nowhere near in sight. Hopefully investors they can wade throught the thicket of funds and their claims of superiority to build efficient, and cost-effective portfolios.

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