Fundamental indexes worth a look for portfolio

| Monday, March 25, 2013, 12:01 a.m.

Every so often, a revolutionary idea turns out to be quite true. Most people, for example, now believe that low-cost index funds can often clobber a high-cost, actively managed mutual fund.

Now there's a new twist on indexing, called fundamental indexing, that's rattling the mutual fund universe. Although the jury is still out on fundamental indexing, it does seem promising — and certainly a far better development than the recent spate of highly specialized index funds that have plagued the industry.

The theory behind index funds is fairly simple. It's extremely difficult to outperform a stock index such as the Standard & Poor's 500 with any regularity. It's even harder if you're charging 1.5 percentage points a year for active management. It's like carrying a couple of barbells during a marathon. The guy without the barbells is probably going to win over the long run.

No surprise, then, that the two largest stock mutual funds are index funds. (SPDR S&P 500 and Vanguard Total Stock Market, measuring by single share class.) From a fund company's perspective, however, indexing has one big problem: a relatively limited universe. How many funds do you need that track the S&P 500?

The number of useful, broad-based indexes is relatively small. The fund industry's response has been to create a number of silly — and often expensive — funds based on narrowly defined indexes.

Amid all this fund clutter comes fundamental indexing. Let's start with a little background. Most index funds give greater weight to stocks with the largest market capitalization — number of shares outstanding multiplied by share price. The 10 largest holdings in the S&P 500 account for 18.88 percent of the index.

One criticism of weighting by market cap is that the very largest stocks can be overvalued.

A simple solution would be to weight each stock equally — a strategy that does best when most stocks, rather than a few, are rising.

Fundamental indexing is another way to address the problem. It weights stocks by criteria other than market cap — dividends, for example, or sales or earnings. A few fundamental index funds have five-year records, and the results are mixed.

Charles Schwab & Co. has rolled out five fundamental index funds, using the methodology advanced by Rob Arnott, head of Research Affiliates and a founder of fundamental investing. These funds use a combination of retained operating cash flow, adjusted sales and dividends plus buybacks to weight stocks.

Adding a fundamental index or two to your portfolio might not hurt — and could actually help.

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