Index investing used to be simple: Pick the index you want to track, then find the cheapest index fund to track it. Alas, in the constantly-evolving world of Wall Street, it’s all about making an effective strategy smarter and cheaper, as Fidelity has shown with its new zero-percent expense ratio Fidelity ZERO Index Funds, debuting Aug 3.
What began as a single price-weighted index with the Dow Jones industrial average became the more mathematical market capitalization-weighted indexes. Now smart beta index funds are showing just how nuanced index investing can be.
As money managers get more clever with their index strategies, investors need to get smarter in their index fund selection.
“Looking at an index fund shouldn’t be any different than looking at an actively managed solution,” says Marc Zeitoun, head of strategic beta at Columbia Threadneedle Investments in New York.
Index investors need to do their due diligence and understand the pros and cons of any strategy.
Price-weighted indexes don’t consider market value. Once upon a time, there was only price weighting.
Price-weighted index strategies came about with the creation of the Dow back in 1896 and have since largely become relegated to the Dow alone.
A price-weighted index holds the same number of shares of each stock, regardless of price. So the Dow holds the same amount of Boeing Co. (ticker: BA) and Intel Corp. ( INTC). But because Boeing’s shares trade at seven times Intel’s, Boeing has a larger weight in the index even though Intel, with its higher market capitalization, represents a larger share of the overall market.
Market cap indexes provide low-cost, straight-forward market exposure. To address this incongruity, market cap-weighted indexes like the S&P 500 were created. In a market cap index, the securities are held in proportion to the total market value of their shares. So Intel carries more weight in the S&P than Boeing.
For the mathematically-inclined, market cap weightings are calculated by multiplying the total number of shares by the share price.
Market cap indexes have become what most people think of and news anchors refer to when discussing the market (with the exception of the Dow, of course). This is one appeal of these strategies: They’re the common language.
They’re also the cheapest index funds.
“There’s not a lot of proprietary thought or investment rigor that goes into them,” says Pierre Caramazza, senior vice president and head of Private Wealth ETF distribution at Franklin Templeton Investments in St. Petersburg, Florida, “so you don’t charge a ton for it.” Or anything at all, if you’re Fidelity. Their zero-percent expense ratio index funds, the Fidelity ZERO Total Market Index Fund (FZROX) and Fidelity ZERO International Index Fund (FZILX), will track the entire U.S. stock market and international markets, respectively.
Since market cap funds keep things simple, they have a low tracking error to the overall market.
[See: 8 Cheap ETFs to Build Your Nest Egg.]
The downsides of market cap index funds. But market cap-weighted index funds have their pitfalls, too. “A lot of people overlook the biases and risks in market-weighted strategies,” says Chicago-based Chris Huemmer, senior investment strategist at FlexShares. For instance, they have a “bias toward large stocks and companies that have strong momentum.”
Market cap funds give greater weight to securities the market has already rewarded, rather to those with greatest future opportunity, Zeitoun says. This makes them prone to concentration risk when a given sector is bid up, as evidenced by the tech-heavy S&P 500, which has suffered from a level of volatility investors may not have welcomed.
Likewise, since investments are weighted based on market value, overvalued companies will have a higher weight than undervalued companies. This isn’t an issue if you believe stocks always trade at fair value, but can deter value investors.
| Pros of Market Cap Indexes | Cons of Market Cap Indexes |
| Cheapest | Bias toward large stocks |
| Easy to understand | Concentration risk |
| Low tracking error to the overall market | Favors overvalued companies |
Equal weight indexes improve diversification but increase costs. To compensate for this, you could give all securities equal weight. In an equal-weight index, Boeing and Intel make up the same proportion of the portfolio. While this improves diversification in the fund, it also gives smaller companies a larger weight. As a result, your S&P 500 fund may behave more like a mid-cap fund than a large-cap fund, meaning more growth potential but also more risk.
Equal weight indexing is also more costly to maintain. Managers must constantly rebalance their funds as prices change, resulting in higher transaction costs which can eat into an investor’s returns.
| Pros of Equal Weight Indexes | Cons of Equal Weight Indexes |
| More diversified | Costly to maintain |
| Higher return potential | Higher risk |
Smart beta indexes provide for other goals. Enter the argument against using price as a determining factor in fund weightings. Smart beta strategies attempt to do the same job as other index funds but in a (dare we say) smarter way. Often this means controlling for risk, Caramazza says. And by risk he means volatility, or how bumpy your ride is.
Smoothing the ride is one way to help people stay invested over the long-term, Caramazza says. A risk-weighted index could do this by tracking the S&P but underweighting tech companies, which tend to be more volatile, he says. Hopefully by doing this your index fund will drop by less than the overall market.
[See: 8 Do’s and Don’ts During Market Volatility.]
Drawbacks of smart beta index funds. But, if you shelter yourself from downside, you’ll also have to give up some upside. Own fewer shares of tech companies and you don’t get to partake in as much of their gains when they have a good run. In other words: Smoother rides cut both ways.
Smart beta funds can target other factors, or what Zeitoun calls fund “personality traits,” too. For instance, income investors may opt for a dividend index fund that emphasizes dividend-paying companies.
When you start targeting specific factors, you run the risk of that factor underperforming and pulling your fund down with it, Huemmer says. And as these strategies get more complicated, their success increasingly depends on the expertise of the folks managing the fund. They can also have higher expense ratios — not an issue necessarily if the fund can compensate with added value.
Choosing your index fund starts with knowing where you’re going. Ultimately, “there’s no one perfect solution,” Huemmer says. Each index investing strategy has its pros and cons; the question for index investors is which attributes matter most to them.
The key to choosing the right index fund is knowing where you want to go and how you want to get there, Caramazza says.
[See: 10 of the Best S&P 500 Dividend Stocks.]
If you want the cheapest ride to stock market exposure, for instance, market cap indexes are probably for you. But if you want to add a few more songs to your playlist, such as dividends or lower volatility, it’s time to look at smart beta funds.
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Be a Smarter Index Fund Investor originally appeared on usnews.com
