Going Beyond the Index

Financial professionals pride themselves on the idea that they can outperform index funds. Yet some pros have apparently decided that if they can't beat the indexes, they'll join them -- with a twist.

The idea behind index funds is simple -- develop an index that fairly represents the broad market or narrow sector or industry in which you want to invest, and then spread your investment dollars across all the stocks in the index. Investors who use index funds can make their financial lives much less complicated, with little effort beyond making regular contributions and following the results.

Enhancing the index?
However, innovation demands new products from financial services companies. In exchange-traded funds, the latest craze, investors who want to match traditional index funds can already use large, well-established index-based ETFs like the S&P 500-tracking SPDR Trust (AMEX: SPY), or Spiders, and the tech-heavy Nasdaq 100 Trust (Nasdaq: QQQQ). As a result, new ETFs have to add a new dimension to the traditional index fund to compete.

Enter WisdomTree. This tiny new money manager has made a big splash in the ETF world by offering index funds with a different philosophy. Rather than using a weighted index based on the market cap of the component stocks, WisdomTree ETFs base their portfolio allocations for index components on fundamental aspects of those stocks, such as dividend yield and company earnings. This results in some big differences from the weights that traditional index funds use, as you can see below.

Nothing new under the sun
Yet this isn't the first time that fund managers have sought to tweak indexes to get better returns. Funds like the Morgan Stanley Equally Weighted S&P 500 (FUND: VADAX) have existed for years, rejecting the market-cap weighted method in favor of investing the same amount of money in all 500 stocks in the index. That basic strategy has done exceedingly well in recent years, outperforming both during the bear market of 2000 to 2002 and the ensuing bull market, as the largest companies in the S&P 500 haven't done as well as their somewhat smaller counterparts.

It's way too early to conclude whether WisdomTree's new ETFs will enjoy the same high performance. Although the manager has back-tested its strategies with positive results, only time will tell if making modifications to market indexes based on earnings and dividends will bring success to investors.

For related articles:

• Not Your Father's Index Funds
• A Great First Investment
• 57 Flavors of Funds

Learn all about the latest twists on exchange-traded funds in our ETF Center. For more in-depth coverage of the world of ETFs and mutual funds, try out our Champion Funds investment service. Foolish fund expert Shannon Zimmerman brings you analysis and fund recommendations each month. You can take a free look for 30 days.

Fool contributor Dan Caplinger has a few index funds in his portfolio, but he doesn't own shares of the companies mentioned in this article. Microsoft and Wal-Mart are Inside Value recommendations. The Fool's disclosure policy goes beyond your expectations.