Index mutual funds have become an important vehicle for many individual and institutional investors since John C. Bogle, founder of The Vanguard Group Inc., pioneered them in 1974.
In fact, Malvern, Pa.-based Vanguard has $350 billion invested in its equity index mutual funds and $60 billion in its fixed-income index funds. Fidelity Investments of Boston, Pacific Investment Management Co. of Newport Beach, Calif., and a number of others also offer index mutual funds.
Index funds have become as popular as the core portfolios in many investment strategies, because they offer low-cost diversification and promise returns, after expenses, very close to those of the market.
Some of the largest institutional investors, such as the California Public Employees' Retirement System of Sacramento, buy their broad diversification cheaply using the index funds and then try to add value using "satellite" active management firms in less efficient sectors, such as small-cap value and small-cap growth.
Some financial planners and investment advisers have used the same approach for their clients.
Until recently, all equity index funds were capitalization weighted, because the underlying indexes are. But now investors are being offered fundamental index funds, which proponents argue overcome what some see as a weakness of conventional index funds.
The perceived weakness is that, in a capitalization-weighted index fund, companies that are overvalued will have extra weight.
In the words of Carmen Campollo, senior vice president of relationship management at FTSE Americas Inc. of New York, and Jason C. Hsu, principal at Research Affiliates LLC of Pasadena, Calif., in the January/February issue of the Journal of Indexes: "A passive index investor is forced to allocate more of his portfolio in overvalued stocks and less of his portfolio in undervalued stocks, exactly the opposite of what common sense investing would suggest."
They argued that research shows that non-capitalization-weighted portfolios outperform standard-cap-weighted portfolios. They also claimed that a back test showed that 23 fundamental indexes outperformed the appropriate MSCI cap-weighted indexes by 2.8 percentage points, on average, over the 20 years ended December 2004, with slightly less volatility.
Fundamental indexes weight their holding in a different manner from cap-weighted indexes. The fundamental index developed by Research Affiliates weights its holdings based on financial factors such as cash flow, sales and book equity value.
Safian Investment Research in White Plains, N.Y., offers a fundamental index in which sectors are weighted by their contribution to the U.S. gross domestic product. Individual stocks within the sectors are selected based on their quality ratings, sales volume, growth in sales and profits, etc., and are price weighted.
Pimco offers a retail mutual fund based on the Research Affiliates index - the Pimco Fundamental Index Plus Total Return Fund, which has $495 million in assets - and PowerShares Capital Management LLC in Wheaton, Ill., offers a fundamental index-based exchange traded fund.
No fund company yet offers a fund based on the Safian index, but additional fundamental index products are coming, including one being developed by Jeremy Seigel, a professor at The Wharton School at the University of Pennsylvania in Philadelphia and author of "Stocks for the Long Run."
Gus Sauter, Vanguard's chief investment officer, said the company has no plans to add fundamental index funds because it already offers index funds with all the factor exposures the fundamental funds offer.
"If you look at what's going on inside these indexes, they exhibit a value and/or a small-cap bias," he said. Vanguard already offers small-cap-value and small-cap-growth index funds, as well as mid-cap index funds.
Regarding the argument that conventional index funds lead investors to allocate increasing amounts to overvalued stocks, Mr. Sauter said that that assumes mispricings are random.
"Maybe they are, but maybe they aren't," he said. "If they are random, cap will overweight and underweight, but does that mean that fundamental factors won't overweight or underweight even more?"
Back tests offer some evidence that a fundamental index can outperform the cap-weighted indexes. But, now that there is real money being managed through the Research Affiliates Fundamental index, we will have a real-life test to see if there really is a better way to index portfolios.
Advisers and planners should keep an eye on the test, because the results may be important for their clients in the future.