Fundamental indexes worth a look for portfolio
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.