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In the money management world, everyone aims to outperform the market. Given how hard that often proves to be, many investors decide to give up trying, and instead settle for matching the returns on benchmark indexes by buying index funds. However, there's a third alternative that may give you the market-beating returns you're looking for.
Building a better mousetrap
When it comes to investing, there's nothing simpler than an index fund. They're incredibly transparent; by looking at the index, you should be able to figure out exactly what your index fund owns at any given time. Compared to active investing strategies, index funds are almost always incredibly inexpensive. By using index funds, you can stop worrying about selecting individual stocks, and instead focus on finding the right mix of different kinds of assets to build an asset allocation strategy that will work best for your goals and risk tolerance.
But the temptation to try to do better than index funds remains. In particular, the rules index funds follow make them prime targets for opportunistic investors. The annual rebalancing of the Russell indexes last Friday is just one of the many inefficiencies that index funds suffer, as funds must follow suit when companies are added to or removed from the indexes they track.
The obvious place to start tinkering with index funds lies in how their components are weighted. Some argue that by loading up on highly valued stocks like Apple and IBM, traditional index funds end up missing out on the opportunities that somewhat smaller stocks could give investors.
That's the logic behind equal-weight indexes. For instance, the Rydex S&P Equal Weight ETF (NYSE: RSP ) owns roughly equal shares of every stock in the S&P 500. That has allowed it to benefit disproportionately from the fortunes of strong stocks among the smaller tier of the S&P, including Cliffs Natural Resources (NYSE: CLF ) , Union Pacific (NYSE: UNP ) , and priceline.com (Nasdaq: PCLN ) .
The story behind why smaller companies have outperformed their bigger brethren varies depending on the company. Cliffs benefited from higher commodity prices following the 2008 bust. Union Pacific in turn helps transport those commodities, seeing earnings increase with a more robust economy. Priceline has been more of an all-weather growth story, seeing explosive increases in revenue and profits since nearly cratering 10 years ago. All in all, equal-weight indexes have done well lately, outperforming market-cap weighted ETFs by more than 10 percentage points in the past year.
Looking at fundamentals
On the other hand, equal weighting doesn't necessarily make intuitive sense, either. Ideally, you'd like to own more of good stocks, and less of bad ones.
That's where fundamental indexing comes in. This strategy involves buying companies based not on their market cap, but rather on other characteristics, such as total revenue, earnings, or dividend payments. You can find ETFs that follow each of these strategies. For instance, RevenueShares Large Cap ETF (NYSE: RWL ) calculates relative weights by revenue, rather than market cap. The WisdomTree Earnings 500 Fund (NYSE: EPS ) weights S&P 500 stocks based on earnings, while its WisdomTree LargeCap Dividend Fund (NYSE: DLN ) uses dividend weighting instead.
These techniques have had mixed results recently. The revenue-based ETF has outperformed the market, but the other two have stayed pretty close to the returns of an S&P 500 index fund in the last couple of years. From a fundamental standpoint, one of the most interesting divergences has come from the financial sector, which was virtually left for dead during the market meltdown in 2008 and early 2009. Dividend cuts and big losses would have taken them completely out of dividend and earnings-based ETFs, but since their revenues continued, a revenue ETF would still have held their shares.
Worth the switch?
The ideas behind these index-fund alternatives make plenty of sense. Different market conditions will make these funds perform in various ways. Sometimes, a traditional index fund will outperform, while at other times, equal-weight or fundamental funds will end up on top.
It's always smart to question conventional wisdom. Even though it's too early to tell whether alternative strategies for index funds lead to clear outperformance, you should keep your eye on them to see if they might make sense for your portfolio.
If you prefer stocks to funds, Morgan Housel has five stocks you can buy today.