Fundamental Weighting Fun

Posted by: Lauren Young on June 26, 2007

This is a guest entry from Benjamin Levisohn (below), who is working as an intern at BusinessWeek this summer. Levisohn is a student at CUNY’s Graduate School of Journalism.

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Yesterday, PowerShares CEO Bruce Bond rang the closing bell at the New York Stock Exchange. The occasion? The launch of four new ETFs based on FTSE RAFI indexes: Developed Markets ex-U.S. Portfolio, Asia Pacific ex-Japan Portfolio, Europe Portfolio and Japan Portfolio.

Ho hum. Another week, another batch of PowerShares ETFs.

I missed the bell ringing – deadlines, you know – but was on hand for the after-ceremony cocktail party, on the NYSE trading floor. I waited patiently for my 10 minutes with Mr. Bond, who was finally pried away from various conversations with suited big-wigs by his PR handler. Standing with three other journalists, I listened as the CEO explained why the new PowerShares ETFs mattered.

His spiel began with a history lesson. First stop, the internet bubble. During those heady times, when it seemed as if anyone with a pulse and CNBC was becoming a day-trader. (I should know, I was one of them.) “Investors inadvertently became speculators,” Bond said. How? They bought market weighted index funds.

“Investors think they’re betting on the economy,” Bond said, “Not the gyrations of the market.” While that statement could be argued – who’s ever heard someone say, “I’ve got my money in the economy”? – because the S&P and the NASDAQ value stocks by their market cap every buyer of these index funds had large positions in companies with little business but lots of speculative value. And when the bubble pops, it takes a lot of individual investor money with it.

The FTSE RAFI indexes seek to eliminate the market weight problem by valuing stocks according to four categories: cash flow, book value, dividends and total sales. Note the absence of market weighting. In theory, the index should value strength of business over market cap.

Bond claims that overseas markets are especially prone to speculative risk. With more Americans investing globally, he believes it makes sense to bring these PowerShares out now, even with the proliferation of international products. “It may be the same country,” he said, “but it’s not the same fund.”

Therein lies the problem. Investors are told that index funds are a safer, cheaper bet than actively managed funds – whether ETFs or traditional mutual funds – but with so many different options for ETF investors out there, how is the average investors supposed choose?

Japan provides a worthwhile example. There’s the iShares MSCI Japan Index (EWJ), a market-weighted index, with a large-cap bent, which is up. The iShares S&P/Topix 150 Index (ITF) tracks an index that is even more weighted toward big companies with enormous market caps. And then there’s the SPDR Russell/Nomura Prime Japan (JPP), which invests in the 1000 largest Japanese stocks and you can toss in two small cap, one dividend and one high yield fund. And that’s just the components. And now PowerShares has entered the arena.

Does a fundamental weighting make more sense for individual investors? Is it just another name for a “value fund,” a claim Bond disputes?

Have fun choosing.

Reader Comments

Roger Nusbaum

June 27, 2007 11:34 AM

I might suggest that there are no short cuts to constructing even a passive portfolio.

How is one to choose? Roll up the sleeves, look at composition weightings for names and sectors, look at fees, even the dreaded back test. I would also look at volatility of of the fund and what it does to the volatility of the entire portfolio.

Further, once you select a fund in a category I think it makes sense to keep in touch (which can be difficult) with new products in the space because some of them will me superior.

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About

Bloomberg Businessweek’s Ben Steverman focuses on the latest moves in financial markets and emerging trends in stocks, bonds, and funds, always with an eye toward giving readers a better understanding of the sometimes confusing and often chaotic world of money. Standard & Poor’s senior index analyst Howard Silverblatt will also provide his take on companies’ finances and the markets. Voted one of the “Top 100 Finance Blogs” in 2007.

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