Not All “Index” Funds Are The Same
May 2, 2008 – 11:30 amBeware of wolves in sheeps’ clothing! Not all funds that call themselves index funds are the same.
In the traditional sense, an index fund is a mutual fund that seeks to match the performance of an underlying financial index. Whether you’re looking to match the total US stock market return by holding the 5000 stocks of the Wilshire 5000 index or match the returns of real estate returns through a REIT index, an index fund is designed to match the performance if it’s benchmark.
Then things start to get blurry. Very smart people start working with statisticians, historical data, and marketing folks and try to improve something. They say “If index funds are so great, why not try to improve them? We’ll just change how the index works, or ‘simply’ pick only the winners from the index and we’ll look like geniuses!”
So here’s what happens:
- fund companies decide to create financial indexes on very narrow sectors or speciality areas
- fund companies try to improve upon well established indexes to improve returns and/or reduce risk.
Let’s look at a few examples. Note that I am not recommending these funds for purchase. I’m simply describing how “indexing” can get blurry. This list of index funds is not exhaustive either, but I tried to choose a few different methodologies for comparison purposes.
Vanguard 500 Index (VFINX)
Seeks to match the performance of the S&P 500, a often-quoted financial index that represents the 500 largest U.S. companies. “Largest” is judged by market capitalization, or market cap for short, which is just the firm’s stock price per share times the number of outstanding shares. You can think of market cap as the cost to purchase every share of the company right at the current share price. Pretty straight-forward with no funny business.
PIMCO Fundamental IndexPLUS TR (PXTIX)
This is an institutional fund run by Bill Gross, the most respected bond investor on the planet. According to PIMCO’s website: “PIMCO manages the Fundamental IndexPLUS TR strategy to outperform the FTSE RAFI 1000 Index by combining a non-leveraged position in swaps on the Enhanced RAFI™ 1000 with a fixed income portfolio, employing two sources of active management for every dollar invested.”
Translation: They’re doing complicated stuff!!!
The FTSE RAFI 1000 index is a market index weighted by four fundemental factors rather than by market capitalization. The four factors are total cash dividends, total sales, free cash flow, and book equity value.
DWS Enhanced S&P 500 Index CL A (OUTDX)
This fund invests “primarily” in companies that are included in the S&P 500, but can also invest up to 20% of assets in investment-grade debt securities (i.e. bonds). Sounds like a manager is picking from the S&P500 companies and then adding in bonds when he/she thinks it’s prudent. This fund also sports a 1.32% expense ratio according to Fidelity and a front end load.
Federated Max-Cap Index Instl (FISPX)
This fund seeks to track the S&P500, but may invest 5% of assets in index futures contracts and options.
Bridgeway Blue-Chip 35 Index (BRLIX)
According to the prospectus this fund seeks “long-term total return on capital” (surprise surprise). It is an “index” fund based on a custom index created by the funds’ adviser. Apparently the fund typically invests 80% of the assets in companies in the custom index, but it can invest the remaining 20% in other securities. My opinion: they have a proprietary secret index, and yet they still have the flexibility to deviate from that index!!! At least the expense ratio is low, at 0.15%.
S&P 500 2x Strategy (RYTTX)
This fund seeks to double the performance of the S&P500, I can only assume by using leveraged instruments like futures and options.
Direxion S&P 500 Bear 1x Inv (PSPSX)
According to MSN Money Central this fund “seeks to provide investment returns that inversely correspond to 100% of the performance of the S&P 500 Index”. I understand correlation and efficient market theory, but please don’t get suckered into thinking of this type of fund as a traditional index fund.
In summary, can some money mangers beat the market, either by selecting investment based on their own skill and analysis? Yes. Can some do it even after covering the expenses to run the fund company, pay commissions on trades, and pay their own salary? A few. But if you can’t identify these winning fund managers in advance with consistency, choosing an “index fund” that uses an unproven methodology is taking a step backwards toward active management in my opinion.
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