Across My Desk: Index Funds

Index funds have their place in one's portfolio. For some investors it's their only investment product; for others it's part of the mix. Whatever your take is, the following piece about equal-weighted indexing written by Kristen French and published on April 30 is worth a read:

"Equal and fundamental indices have outperformed market-cap weighted indices by a meaningful margin over the past 18 years, according to a recent white paper released by Standard & Poor's. But cap-weighted indices tend to outperform during bull markets, or when mega-cap growth stocks are doing best, the research showed.

The finding isn't that surprising, since Standard & Poor's research basically supports what analysts have been saying since fundamental indexes were pioneered few years ago.

Since 1990, when it was created, the S&P 500 EWI (equal-weighted index) has outperformed the S&P 500 (a cap-weighted index) by 1.5 percent per year. Over the full period, the S&P 500 equal-weight index notched annualized returns of 12.0 percent versus 10.5 percent for the S&P 500.

"Over the long term, equal weighting does perform better, on an absolute and risk-adjusted basis," says Srikant Dash, head of global research and design at Standard & Poor's. Unlike cap-weighted indices, which have been around for much longer, the components of equal-weighted indices are, well, equally weighted. In other words, there is no bias towards market cap, dividends, sales or any other measure that may or may not be in favor in the markets at a particular time. "Equal weighting just randomizes your exposure to risk factors so you don't have to worry about which risk-factor exposure you want to take."

The thing is, fundamentally weighted indexes, or indexes that are weighted according to some fundamental metric (such as sales or dividends), appear to have outperformed the S&P 500 equally well over time horizons of 20 to 40 years, says Dash. "This can be very well explained by the fact that value outperforms growth over the long term, which has been a well-accepted principal of finance for years."

But critics of cap-weighted indexing, like Rob Arnott, the founder of investment management firm Research Affiliates, say that there's more to it than that. Basically, Arnott and his compatriots argue that cap-weighted indexing exaggerates the inefficiencies in the market, rather than taking advantage of them. For example, the S&P 500 gives greater weighting to stocks that are overpriced by the market, and under weights stocks that are under-priced. (For more on this, see Registered Rep.'s April 2007 cover story, "The Fundamentalist.")

Dash still thinks that cap-weighted indices serve a purpose, depending on the length of an investor's time horizon, and where that time period falls in the market cycle. Over the past one- and three-year periods, for example, the S&P 500 outperformed the equally weighted index: The S&P 500 gained 5.5 percent and 8.6 percent, respectively, over those periods, while the equally weighted index returned 1.5 percent and 8.3 percent. Whether you believe in one kind of indexing or another ultimately comes down to how efficient you think the market actually is, and whether you believe that individuals can actually beat the market, says Dash. That debate probably won't blow over any time soon.

In the meantime, equal-weighted indexing is gaining popularity. Assets allocated to the strategy soared to $8.5 billion in 2006 from $2.3 billion in 2003, the Standard & Poor's report shows. Today there are numerous pension and institutional funds, mutual funds and ETFs linked to equal-weighted indices.

Equally weighted indices have been criticized for having higher turnover, due to the quarterly rebalancing of the portfolio, and the potential for liquidity problems in smaller stocks in the index, but Standard & Poor's suggests these should not be major concerns. For one, while the S&P 500 equally weighted index has much higher turnover than the S&P 500, so do most alternatively weighted indices. Meanwhile, liquidity and capacity are only constraints in theory, the study found.