Index Fund Investing: Why Index Funds Underperform the Market… and How Investors Can Reduce Their Risk

by Mark Skousen, Chairman, Investment U
Wednesday, September 20, 2006: Issue : #581

Sure, you’ve heard the benefits of index funds…

But ordinary index funds have a major flaw: They are “cap weighted.”The good news is that index fund investing is evolving. One fund in particular is taking a much different approach. And it’s paying off, too…

Basically, Standard & Poor’s, Dow Jones, Russell and other indexers weight each stock in their index according to market capitalization. This is great during a secular bull market, but could be a disaster during a bear market.

Why Index Funds Often Fail to Beat the Market

Last week I had lunch with mutual fund guru Sheldon Jacobs, founder of the No-Load Fund Investor. His mutual fund portfolio is ranked #1 over the past 20 years in risk-adjusted return.

Sheldon told me an amazing fact about cap-weighted index funds by comparing General Motors (NYSE: GM) with Google (Nasdaq: GOOG). GM is by far the bigger company (#3 in the Fortune 500). Sales are 32 times greater, and GM has 57 times more employees. GOOG isn’t even in the top 200 companies in the United States. Yet GOOG is weighted much heavier than GM in the S&P 500.

In fact, for every new dollar you invest in the S&P 500 Index, 7.5 cents goes into GOOG stock and 1 cent goes into GM!

Cap-weighted stocks are never rebalanced in an index fund. This is fine in a secular bull market, where you’re riding with your winners. But in an up-and-down market like now, index funds can create a drag on your performance.

Sheldon revealed another shocking statistic: In the five years ending December 1999 (a major bull market), the Vanguard 500 Index Fund ranked in the first quintile of all growth and income funds. However, in sharp contrast, for the years ending December 2005 (a bear market), the same fund ranked in the fourth quintile!

There Is Hope for the Index Fund Investor

What to do? Invest in an index fund that is weighted by fundamentals, not market cap. That is, where index fund managers weight their index by fundamentals such as book value, free cash flow, sales and dividends. Research shows that by investing this way, an index fund can increase its overall return with less volatility.

Smart Money recently reported:

“Independent research appears to back the fundamental indexers. Constructing portfolios based on earnings, dividends, sales or book value going back five, ten and twenty years across markets in the U. S., U. K., Europe, Southeast Asia and Japan, a London research firm Style Research concluded that fundamental indexing outperformed cap weighted index funds on an average 2%-2.5% a year.”

Jacobs told me about a fundamental value exchange traded fund that is already doing this: the PowerShares FTSE RAFI US 1000 (NYSE: PRF). Take a look…

It’s up 6.1% year to date. And as the graph shows, in its first year of trading, PRF is beating the S&P 500.

Good investing, AEIOU,

Mark

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