ETFs: Index Funds Are Still a Good Idea

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In August 2006, when market preference began to shift from small- and mid-cap stocks to large-caps, the Market Grader 40 portfolio was oriented more toward small-caps. "Obviously, you wanted to sell the index down and put it back into large caps, but that wasn't the rule of the index," Freedman says. "When small- and mid-caps rebounded in February 2007, the system moved back to a small-cap bias and because of the discipline of the system produced massive returns."

Year-to-date as of the end of August, the MarketGrader 40 fund had lost 9.97% of its value, vs. a 11.39% decline in the S&P 500 Index. The Market Grader 200 was down 8.83%, and the Market Grader 200 was down 11.76% over the same period.

TOO COMPLICATED?

One challenge in getting people to warm to active ETFs has been a general backlash in the financial industry against quantitative models due to the losses they generated for clients earlier this decade and the view that they're too complicated for most investors to understand, says Freedman. SPA's quant model is entirely company-specific and doesn't include economic, inflation, or trade-weighted inputs, he adds.

Ed McRedmond, senior vice-president of portfolio strategies at Invesco PowerShares in Wheaton, Ill., says money flows into PowerShares ETFs have been slow, with investors adopting more of a wait-and-see approach than they did when the first index ETFs were launched in the 1990s.

Wisdom Tree Investments' (WSDT) foray into active equity ETFs began in June 2006 and stemmed from research showing that, by correcting a flaw in capitalization-weighted indexes, higher returns could be generated over time with less risk. "Once you realize you have a better mousetrap, you want to commercialize it, and commercialize it within the best structure, within ETFs," says Bruce Lavine, president and chief operating officer of Wisdom Tree.

The investment firm offers 41 equity ETFs that sample Wisdom Tree's own indexes, which are weighted based on the size of companies' annual dividend payouts or earnings instead of their market caps. Since the funds are rebalanced just once a year, stocks are removed between rebalancings only if they cancel their dividend, file for bankrutcy, or de-list from a major exchange, says Luciano Siracusano, director of research at Wisdom Tree.

FINANCIAL WHIPPING

Year-to-date through Aug. 31, Wisdom Tree's domestic ETFs have mostly underperformed their comparable cap-weighted indexes, such as the Russell 3000. That's because of the whipping financial stocks have taken since the credit crisis began a year ago. "When you're in a fundamentally weighted fund in the U.S., more of the weight is tilted toward financials because they pay higher dividends and they had higher earnings last year, and we set our weights once a year," says Siracusano.

The returns on Wisdom Tree's 19 international equity ETFs came much closer to matching the returns of their cap-weighted benchmarks, such as the MSCI EAFE Index, for the first eight months of this year, and 16 of them have outpaced the indexes since inception as of Aug. 31. Siracusano says there's a case to be made for the fundamentally weighted index approach, given how well it has held up in an environment where growth strategies have outperformed value strategies.