Non-traditional indexes gaining ground in ETF world

Feb 12, 2007 @ 12:01 am

By David Hoffman

PHILADELPHIA — When it comes to new indexes, those that eschew weightings based on market capitalization are all the rage.

XShares Advisors LLC of New York has in registration 20 exchange traded funds based on indexes from upstart IndexIQ Inc. The funds will track indexes weighted by such hard-to-measure factors as innovation or productivity.

Traditionally, ETFs track indexes that weight stocks based on market cap or total stock market value.

The IndexIQ indexes are intended to combine the performance characteristics of active managers with the benefits of passive indexing, said Adam S. Patti, chief executive of IndexIQ in Rye Brook, N.Y. The company, which has been in existence only since June 1, has developed 200 indexes, around which additional ETFs are planned, Mr. Patti said.

VTL Associates LLC of Philadelphia is another firm with ETFs in registration that avoid using market capitalization. The firm’s three ETFs are weighted by the size of company revenue, said Vincent Lowery, its chief executive and chief investment consultant.

Of course, VTL Associates and XShares Advisors aren’t the first to launch ETFs that follow indexes weighted by factors other than market cap.

WisdomTree Investments Inc. of New York uses dividends to weight the indexes underlying its ETFs; and Rydex Investments of Rockville, Md., has developed ETFs that follow equal-weighted indexes.

PowerShares Capital Management LLC of Wheaton, Ill., offers ETFs that follow “fundamental indexes” developed by Research Affiliates LLC of Pasadena, Calif., which select and weight index components based on a combination of sales, income, book value and dividends.

Indexes that weight stocks on factors other than market capitalization began growing in popularity a couple of years ago when ETF providers started to look around for new indexes upon which to build new ETFs, according to industry experts.

Proponents of such indexes say that they deliver better performance than indexes that are weighted by market capitalization.

In the case of the indexes tracked by the proposed IndexIQ ETFs, they follow a distinct set of rules that allow them to “hew to the passive-index structure” while attempting to outperform traditional indexes, Mr. Patti said.

Similar sentiments were expressed by Mr. Lowery.

But such statements, however, are akin to false advertising, said John Bogle, founder of The Vanguard Group Inc. of Malvern, Pa., and a vocal proponent of market-cap-weighted indexes.

Indexes designed to “improve” upon traditional market-cap-weighted indexes don’t have the same risk characteristics, and to suggest they do is misleading, he said.

“They will depart from market return,” Mr. Bogle said. “Therein lies the risk.”

Such risk is real, said Srikant Dash, an index strategist with Standard & Poor’s in New York.

If the market turns, there is no way investors will know how the new indexes will respond, he said. Although it is true that they all have been back-tested, that doesn’t necessarily give investors an idea of how the indexes will perform in the real world, Mr. Dash said.

“Significant education is needed,” he added. “Unfortunately, the market has not done a good job at educating different distribution channels or retail investors.”

More education is needed, Mr. Patti agrees. But he bristled at the notion that somehow his company’s indexes are not at least similar to traditional passive indexes.

“If you see what’s out in the market today … a lot of people are developing rules-based strategies that are pretty active strategies, pretty high turnover,” Mr. Patti said.

The indexes designed by IndexIQ, however, are designed to have low turnover, he said.

The indexes that underlie VTL’s proposed ETFs also have been designed to have low turnover, Mr. Lowery said.

At least one financial adviser, however, said that the issue of whether the industry is doing a good enough job distinguishing the risk associated with new indexes that aren’t weighted by market cap is overblown. “I think that the big advantage of index investing isn’t necessarily that it’s low risk,” said James Kibler, president of Eldridge Financial Planning LLC in New York.

The only way to evaluate the risk associated with a particular index is to give it time and see how it performs, he said. Only after it has had a few year’s performance under its belt would it be wise to draw any conclusion, Mr. Kibler said.

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