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By Brian Evans

A broad-market index matches as closely as possible the return of the overall stock market. So if funds seek to track U.S. stock market indexes and the stock market continues to set record highs like Monday, July 22nd, then why would investing in these indexes not be beneficial? Read this investor insight by Madrona Funds breaking down the popular indexing options in today's market and the flaws that lie in each methodology.

It has been more than 35 years since the first broad market index funds debuted. At the time, they were a cutting edge strategy for core equity allocation. Today, index funds are a major part of 401(k) and other retirement plans, particularly ones tracking the Standard & Poor's 500. But they have deep flaws.

Prior to index funds, investors could not assemble broad baskets of equities because trading costs to buy 500 or so stocks were high. The composition of index funds is the problem. For one thing, indexes like the S&P 500 focus on the most popular, highest valued stocks and slight the most undervalued equities in the market.

In our experience, most successful investment advisors avoid the methods used in selecting stocks for index funds. Instead, they work to find the best projected future company performance relative to its stock's current price.

Before the index option, actively managed mutual funds were the first products to allow individual investors wide-ranging access to the markets. Managers select stocks depending on their own philosophies and criteria - growth, value, blend and so forth. There are good fund managers, especially among industry sectors. When an investor seeks to concentrate on a particular area of the market, sector funds are an answer.

However, investing in a broad expanse of the market (the S&P 500 covers roughly three-quarters of the U.S. market's value) can't be done this way. One longstanding argument for buying an S&P 500 fund is diversification - your fortunes rise or fall with the overall market, or at least a large and presumably representative part of it.

Trouble is, most active mutual funds don't perform as well as their indexed counterparts. A 2009 research paper, The Morningstar Box Score Report, concluded: "After accounting for risk, size and style, only 37% of active funds beat the respective Morningstar Style Index over the past three years." When it came to the large-cap core style, less than 23% of managed funds beat their Morningstar style benchmark for the five years ending June 30, 2009. Similar studies show the same thing.

Since the first index fund, the financial services realm has created new weighting systems for index funds. They all still contain flaws:

Market-capitalization weighted index. This is the oldest and most widely used method, and perhaps the least logical. It relies overwhelmingly on one factor - size. The bigger a stock's market valuation, the bigger its weight in the index. For the S&P 500, information technology is the largest sector and Apple (AAPL) has the 2nd largest weight, followed by Microsoft (MSFT) at 3rd. This index is the realm of the largest U.S. stocks. S&P rebalances it in light of how each member stock's valuation rises or falls, which means buying those stocks that are getting more expensive and selling those that are getting cheaper. Market-capitalization weighting for the S&P 500 assumes that:

  • A mega-cap stock is always a better investment option than any mid-cap stock.
  • It is desirable to allocate more than 60% of your total investment in the first quartile of the 500 largest U.S. companies. Similarly, it makes sense to only allocate less than 40% of your total investment to the next three quartiles combined.
  • Buying more of a stock after it increases in value and sell it after the price drops is a good idea.
  • It is better to make the largest allocation to overvalued sectors and conversely, divest the highly profitable, but unpopular sectors. For example, in February 2000, the technology and telecommunications sectors represented more than 50% of the equity market's total value. These sectors were the most overvalued in modern history.
  • Excluding any index-member equities is not done, even if they are bad investments. Obviously, no active management is allowed. Selection and weighting of members are on auto-pilot.

Dividend or revenue-weighted index. Due to the market-cap method's weaknesses, new products arrived using other simple measures to allocate investments by using dividends paid or revenues earned. In many cases, these measures are an improvement on the market-cap method simply because there's less bias to buy equities when they are high and sell them when they are low.

But these methodologies have their own biases.

With dividend weighting, the tilt is toward high-payout sectors, such as banks, utilities, pharmaceuticals and real estate. This method shies away from growth-oriented companies and those exploring new areas. Additionally, the top holdings of a dividend-weighted index looks a lot like those in a market-cap index. The reason is that the highest allocation is not to the companies paying the highest percentage of earnings in dividends. Rather, it is to the companies with the highest total dollars of dividends paid. That dramatically overweights mega-cap equities.

Similarly, revenue weighting ignores the costs of obtaining that revenue. Here again, mega-cap companies dominate.

Equal weighted index. With this kind, weighting are identical for the largest valued stocks and the smallest. A review of the one-, three- and five-year returns indicates that this method outperforms the previous two strategies. For much of the past few years, smaller stocks did very well. This will not always be the case.

The financial community, with access to vast amounts of company data, seems to be saying: "We don't have any idea which companies make the best investment, so let's just make an equal investment in all of them."

Historical based fundamental index. Investment allocations here are based on a combination of historical accounting measures such as net cash flow, accounting book value, dividends paid, revenues and return on assets.

While this represents some progress, it is also steeped in flaws. First, there is still the bias toward overweighting mega-cap companies. Once again, this is due to using gross numbers rather than percentages. This results in an index strategy with remarkably similarly ranked holdings as the S&P 500, with a particularly strong overweight to the first quartile and even more specifically the Top 25 holdings.

Not only does this strategy rely solely on gross numbers, but the data used to determine the rankings are purely historical and admittedly fail to take into account the price of the individual securities. When making any business decision, it is important to take the past into account but the oftentimes muttered financial disclosure, "Past performance is not indicative of future results," reigns true. A decision to purchase an ownership stake in any venture must take into account the future profitability expectations as well as the price to make an informed decision and this strategy simply fails to do so.

As with the other index methodologies, an investor is not likely to use this approach to analyze an individual equity for purchase or sale. So why build an entire broad-market index on this?

Source: What's Wrong With Indexes?

Additional disclosure: To the extent that this content includes references to securities, those references do not constitute an offer or solicitation to buy, sell or hold such security. AdvisorShares is a sponsor of actively managed exchange-traded funds (ETFs) and holds positions in all of its ETFs. This document should not be considered investment advice and the information contain within should not be relied upon in assessing whether or not to invest in any products mentioned. Investment in securities carries a high degree of risk which may result in investors losing all of their invested capital. Please keep in mind that a company’s past financial performance, including the performance of its share price, does not guarantee future results. To learn more about the risks with actively managed ETFs visit our website AdvisorShares.com.