The New Indexing

Index investing has been around for a long time. The Vanguard 500 fund was formed in 1976, and institutional indexing is older still.  The attractions are abundant: inexpensive implementation, broad diversification, complete exposure to a market, straightforward monitoring. 

Traditionally, indexes have been constructed on a cap-weighted basis.  This was done so that the performance of the index would reflect the return available to an investment in the entire market, the investable universe.  Thus, a security that represents more invested capital, or a higher market capitalization, is included in the index with a greater weight than a security with a lower market cap.

This size-weighting is counter-intuitive, given the studies suggesting that superior returns can be earned by investing in small companies, companies with low P/E ratios, and companies that pay dividends.  For a long time, these anomalies were exploitable only through active management, along with the higher implementation costs.  Consulting firm Russell Investments was one of the first to formalize a set of indexes to measure size and style cohorts that were fully inclusive and accounted for the entire capitalization of the market.  Investable products followed.  But the indexes were still cap weighted.

The Wall Street Journal has an article (subscription required) about the new index products that use these factors to create alternative weighting schemes.  The article highlights the funds, both traditional open-end and ETF, that are employing alternative weighting schemes, from equal weighted, to single-factor weighting to Research Associates' Fundamental Indexing.  All of these new weighting schemes tend to outperform cap weighted indexes, though typically with greater volatility. 

Clarity Finance has adopted a paired indexing strategy using both cap weighted and Fundamental Indexing schemes.  Cap weighting ensures close tracking to the return offered by the investable universe and typically lower cost implementation than alternative schemes.  Fundamental Indexing's use of multiple characteristics on which to weight holdings gives a better exposure to economic and (theoretically) return factors.  The experience of the model portfolios has been performance net of fees comparable to the benchmark with similar volatility.