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A fundamentally better indexing strategy

dberman@globeandmail.com

David Berman writes for Inside the Market (tgam.ca/inside-the-market), which offers up-to-the-minute analysis of stock trends and market-moving news throughout the trading day.

Even many index investors want to do better than the index - and it turns out, they can.

So-called fundamental indexing, which weights stocks differently than benchmark indexes like the S&P 500 and the S&P/TSX composite index, is surging in popularity. No wonder: The evidence suggesting superior returns is looking very compelling.

Strategists at Pavilion Global Markets added to the discussion with a report examining long-term returns on alternative strategies tied to the S&P 500, and found that they have done far better than the benchmark index using data going back to 1991.

One strategy draws from the same index, but weights stocks equally rather than by market capitalization. Since 1991, this approach turned a $100 investment into $892, or about 70 per cent more than the benchmark index. The divergence between the two approaches picked up noticeably after 2001.

An index that weighted stocks based on sales outperformed the benchmark by 53 per cent, an index that weighted stocks based on earnings outperformed by 77 per cent and an index that weighted stocks based on return-on-equity outperformed by 114 per cent - an astounding difference when you consider that it still draws from the same 500 stocks as the benchmark index.

While proponents of fundamental indexing are often criticized for using data-mining tricks to make past performance look good, it is hard to ignore results that go back more than two decades and when the data is being crunched by an independent source.

A growing number of investors appear to agree, given the rising popularity of exchange-traded funds that are tied to fundamental indexing (also known as smart-beta funds, factor-based indexing and alternative indexing).

Whatever you prefer to call them, there are now 326 U.S. ETFs that fit the description in one way or another, according to IndexUniverse, and this number doesn't include leveraged and inverse strategies. These funds account for 40 per cent of all U.S.-listed ETFs and about 14 per cent of ETF assets. This year alone, nearly $46-billion (U.S.) has flowed in.

PowerShares is a big player here. Its FTSE RAFI U.S. 1000 ETF has edged past the S&P 500 by more than three percentage points this year. And its FTSE RAFI Canadian Fundamentals ETF has beaten the S&P/TSX composite index by five percentage points this year.

For indexing purists, the rising interest in these alternative approaches suggests that investors are being seduced by something that looks a lot like active investing. That's a no-no that indexing seeks to avoid, for the simple reason that indexes beat most active investors hands-down over the long-term.

But fundamental indexing doesn't chase hot stocks or seek to benefit from stock-picking prowess, as active investing does. It merely ranks stocks in an existing index using different weightings, out of a belief that market capitalization isn't the best approach.

And why would this be? Since market caps are reflections of stock prices, they often reflect investor anxiety and exuberance. Fundamental indexing seeks to rank stocks using a more rational approach.

There is a downside, though. The Pavilion strategists found that fundamental indexing is often more volatile, with bigger losses than plain vanilla indexes during market downturns.

But with significantly higher returns over the longer-term and a sound underpinning that should deliver strong performance in the years ahead, fundamental indexing is a compelling alternative if you can hold on when markets dip.

If indexing beats stock picking, then an approach that beats indexing is definitely worth a look.

© 2007 The Globe and Mail. All rights reserved.

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