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New Method Puts A Twist On Traditional Indexing

For long-term investors, indexing makes a lot of sense. Rather than seeking to out-perform securities markets—a very tall order over the long haul— this strategy uses mutual funds or exchange-traded funds designed to track the performance of various market benchmarks. Properly executed, indexing lets you profit in step with the market, and at a minimal cost, because index funds tend to carry very low investment expenses.

Still, critics of indexing point to a fundamental flaw. The strategy tends to overexpose investors to stocks that may be selling for more than they're worth, while shortchanging holdings in undervalued issues. In early 2000, for example, just before the technology bubble burst, investors in the Standard & Poor's 500 index had 32% of their assets in tech stocks. Yet in 1995, when tech was just beginning its run and it would have been nice to have a healthy position in the sector, it accounted for just 10% of the index.

The problem is in how most indexes are constructed. The vast majority are capitalization weighted. That means a stock's rank and weight in the index is based on its overall market value—in other words, its share price multiplied by the number of shares outstanding. The more a company is worth by this measure, the bigger its share of the index. As a result, indexers get more of stocks selling for above their fair value.

Downplaying costly stocks. Robert Arnott believes he has found a better way. Editor of the Financial Analysts Journal and founder of Research Affiliates Inc., an asset management firm, Arnott has built indexes that rank companies according to four fundamental measures—sales, cash flow, cash dividends, and book value —each of which is given equal weight in determining a stock's position in the index.

The result is an index that has a lower market cap than traditional indexes do, and that tends to give greater weight to value stocks. While many companies populate both kinds of index, there are notable differences in rankings. For example, General Electric, Exxon Mobil, and Microsoft are the three largest stocks in the Russell 1000 index, which bases weightings on market capitalization. In contrast, the biggest stocks in the Research Affiliates Fundamental Index 1000 (RAFI 1000) are, in descending order: Exxon Mobil, Citigroup, and General Electric. Based on its fundamentals, mammoth Microsoft doesn't even make it into the RAFI top 10. "Instead of weightings in bubbles and fads, these indexes give weightings consistent with a company's current place in the economy," says Arnott.

This approach pays off in better performance, Arnott argues. From 1962 through 2004—a 43-year period that begins as far back as the avail-ability of the fundamental data the RAFI index depends on-the S&P 500 returned an average of 10.53% a year. But the RAFI 1000 gained 12.47% annually, according to Arnott's figures.

Moreover, fundamental indexing works particularly well during market downturns, Arnott says. While the RAFI 1000 earned 0.45% more than the S&P 500 during bull markets, it lost 5.85% less during bear markets, according to his calculations.

Arnott admits that when high-multiple stocks do really well, as they did during 1999 and 2000, his index will lag those weighted by market cap. "But that's pretty much the only environment" in which fundamental indexing under performs Arnott says. And while he acknowledges that his fundamental index tends to favor value stocks and, to a lesser degree, those of smaller companies, he contends that capitalization- weighted indexes also have a bias, systematically skewing toward high-multiple growth stocks.

What's your bias? Not everyone is sold on this new indexing approach. Gus Sauter, chief investment officer at Vanguard Group, argues that fundamental indexes indeed are biased toward value and smaller-cap stocks. Consider, for example, that between December 1976 and February 2000, the fundamental index had exactly the same return as the S&P 500, Sauter says. The two periods during which the fundamental index outperformed the S&P 500— December 1973 through December 1976 and February 2000 through December 2004—are exactly when small-cap and value stocks outdistanced the traditional index, he says.

An investor who wants to invest in those stock classes can find plenty of index funds designed to do just that, says Sauter. Moreover, now is not the time to invest in an index that favors value and smaller-cap stocks, he says. Mid- and small-cap value markets have been extremely hot during the past five years, Sauter says, which means they're likely to cool off soon. "When people put money into what they see in the rearview mirror, they get burned," he warns.

Despite such concerns, Arnott's approach to indexing remains intriguing, and as long as funds such as the RAFI 1000 deliver low costs, low turnover, and broad exposure to the market—the hallmarks of any good index fund—they may be worth considering.

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