Investors increasingly seek the set-and-forget index fund with a twist: tweaked market capitalization, according to the San Francisco Chronicle.

Although the S&P 500 offers broad exposure, some believe its marriage to market capitalization weighting had dragged it down in recent years. 

The result is a crop of funds that are tied to indexes, but are weighted by sales, earnings, book value or dividend.

“With a cap-weighted index, you participate in every bubble that comes along,” said Rob Arnott¸ chairman of Research Affiliates in Pasadena, Calif.

Exxon Mobil, the biggest company in the S&P 500 Index, accounts for almost 3.5% of its weight. PMC-Sierra is the smallest company and accounts for only .012%.

Index funds usually try to invest their assets to match the indexes they track.

Arnott relates that cap weighting tends to overweight overvalued stocks and underweight undervalued stocks. “A fundamental index weights companies based on how big they are, not by how much the market thinks they will be worth in the future,” he adds.

Arnott’s indexes have only been around for a few years, but in a back-testing simulation, the RAFI U.S. 1000 hypothetically would have returned 12% to 13 % a year over the past 45 years compared with 10.38% for the S&P, says Arnott.

WisdomTree, which is run by Wharton professor Jeremy Siegel, takes a different approach and has started two lines of fundamental indexes based on a company’s divided yield and earnings. The company has a family of exchange-traded funds tacking its indexes.

Arnott’s firm has licensed its indexes to PowerShares for exchange-traded funds and to Charles Schwab for traditional no-load mutual funds.

Vanguard founder John Bogle still believes that cap weighting is the way to go, although he and Vanguard have been pushing total-market funds over S&P 500 funds for several years.

In an interview last fall, Bogle stated that Arnott and Siegel, “argue fairly enough, that in a cap-weighted portfolio, half of the stocks are overvalued to a greater or lesser extent, and half are undervalued.” The problem is, “who really knows which half is which?”

The staff of Money Management Executive ("MME") has prepared these capsule summaries based on reports published by the news sources to which they are attributed. Those news sources are not associated with MME, and have not prepared, sponsored, endorsed, or approved these summaries.

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