The Anna Maria Island Sun Newspaper

Vol. 14 No. 39 - July 23, 2014

BUSINESS

Anna Maria Island Sun News Story

Index funds continue to evolve

Investment Corner

Investors have a choice when purchasing pooled investment vehicles. Mutual funds or exchange traded funds are available in two varieties. Actively managed funds are directed using the skills of a manager or team of managers to select the securities held in the fund. Index funds hold virtually all the securities in a particular benchmark index with the goal of the performance of the fund mimicking the index. Indexes may be very broadly defined like the World Total Stock Market Index or the well known S&P 500 Index, which targets large U.S. based corporations, or more finely tuned indexes that are populated with companies in a specific region or industry.

The use of index funds has been expanding recently, driven by lower operating expenses, which translates to higher performance if the index fund does as well as a comparable actively managed fund.

A study I came across recently actually shows that the average actively managed fund that uses the S &P 500 as its benchmark beat the index by about 0.1 percent. However, after the aforementioned higher operating expenses the average return was 0.8 percent lower. Score one for the index fund crowd.

Index funds are bound by prospectus to hold the components in a particular index in proper proportion to deliver a return as close as possible to that of the index. Most indexes are capitalization weighted meaning that as markets rise, they have to own more and more of the stocks which have risen the most in price. When the next downturn comes, these best performing companies often turn into the worst performers because they reached over-valued levels. We’re not supposed to keep buying more and more of the most overvalued stocks, right?

Enter the equal weighted index fund. These funds use the approach of owning all the securities in a particular index in the same proportion, mimicking an equal weighted version of the index. These equal weighted funds have shown a lot of promise, I believe for a couple reasons. First, they own as much of the smaller companies in the index as the large. Smaller companies have the potential to grow faster and increase in price more over time. Second, when the inevitable market corrections hit, they are not nearly as concentrated in the companies which have risen the most in the last year or two and may have more downside protection for this reason.

The most significant recent development in index funds is a fundamentally weighted index. These indexes include and weight companies on fundamentally sound metrics of a company’s value as a business. Factors include P.E. ratios, dividends, price to sales ratios, etc. Companies valued too richly will be underweighted or possibly excluded from the index and not held in a fund or exchange traded fund following that index. The fundamentally weighted indexes haven’t really been around long enough to pass judgment, but the historical testing of the theory shows promise.

In a strong upward moving market I would expect the traditional index fund to outperform the newer equal weighted and fundamentally weighted index funds, but in downward trending markets these newer style indexes may have an edge.

Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.

 


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