The newest batch of index-based products aren't your father's plain-vanilla index fund that passively tracks a well-known equity index.

The newest crop of indexed-products being launched in recent months are tied to proprietarily created equity indexes that search for desired quantitative fundamental characteristics of companies and then assemble a unique index of stocks or stocks from a traditional index in a new-fangled combination.

Many of these so-called fundamentally weighted indexes stress particular characteristics singly or collectively, such as cash flow, dividends, revenue or even stock buybacks, and then more heavily weight those component companies with the best features or prospects.

This is in direct contrast to many cap-weighted indexes, such as the S&P 500, which are on auto-pilot and automatically overweight larger companies simply because they sport beefier capitalizations.

Once a proprietary index is created, it's usually just a matter of time before investment products are then created that track to that novel index. Exchange traded funds (ETFs), separate accounts and even mutual funds have been launched from such indexes, and more are expected to come to market soon, some from institutional or relatively unknown sponsors.

"Over the last 10 years, indexing has made strides in gathering assets," said Adam Patti, CEO of IndexIQ, a Rye Brook, N.Y., investment firm that has developed new families of next-generation indexes that employ 20 different methodologies for institutional and wealthy investors. IndexIQ is currently negotiating to license its proprietary indexes to investment sponsors.

"With the advent of ETFs and the growing number of products, indexing has had to grow up and innovate to keep up," Patti added.

The impetus for the creation of these smarter indexed products, proponents say, is to create investment products that employ a low cost/low turnover passive index strategy coupled with the active investment manager's philosophy of selecting stocks based upon a company's attributes. The goal is to outperform traditional cap-weighted indexes and reduce exposure to the largest stocks that dominate indexes by structuring indexes based on something other than pure size of capitalization.

The whole fundamentally weighted investment approach also deep-sixes the much-followed efficient market theory by admitting that market prices are sometimes overvaluing and undervaluing stocks, experts say.

"The key to it is to own everything in the index," said Vincent Lowry, CEO, chief investment consultant and founder of consulting firm VTL Associates of Philadelphia. VTL proprietarily created three indexes that re-weight the components of the S&P 500, the S&P Mid-Cap 400 and the S&P Small-Cap 600 indexes based upon each component company's top-line revenue.

"We have found that active managers underperform more for what they don't own than what they do own," he said.

VTL currently has three ETFs based upon its indexes in registration awaiting approval from the Securities and Exchange Commission. It also filed, more than a year ago, for a patent on its methodology, which will allow the firm to revenue-weight any index, Lowry said. "Dividends and net income are good, but our firm is going to stay with the top-line revenue number," he added. His firm has been researching sector performance, he hinted.

On Dec. 18, Wilmington Trust of Wilmington, Del., launched two new fundamentally weighted indexed mutual funds that borrow their approach from three fundamentally weighted separate account strategies the firm recently launched; one each in the large-cap, mid-cap and small-cap segments. Both funds will weight companies based upon dividends, profits and cash flow, with companies paying larger dividends garnering a larger weighting.

"What we're doing is combining the best of rules-based, transparent, low turnover investing and the ability to outperform like an active vehicle," said Rex Macey, vice president of equity management. "We're not trying to pick stocks or make predictions about the future," he added.

But unlike other firms that track to proprietary indexes, Wilmington will start with the universe of stocks in the Russell 1000 Index for its large-cap fund, and the Russell 2000 Index of small firms for its small-cap fund.

PowerShares Capital Management, now a division of Amvescap, was the early entrant to the fundamentally weighted ETF market by launching its first two in May 2003. The company now sports 70 ETFs that are based on proprietarily created intelligent indexes dubbed "intellidexes". It launched several new ETFs this past October and December, including the PowerShares Buyback Achievers Portfolio that tracks the performance of companies that have repurchased at least 5% of their outstanding shares over the past 12 months.

WisdomTree Asset Management of New York has entered the fundamentally weighted index fund business with a bang. The firm now has 30 ETFs up and running, each based upon indexes that more prominently weight companies with either higher dividends or higher earnings.

"People had concerns about cap-weighted indexes for a long time but didn't have thoughtful alternatives. We've created the opportunity to allow investors to look under the hood at indexing," said Bruce Lavine, president and chief operating officer at the firm.

This past October, ETF giant State Street Global Advisors announced the launch in Australia of the SSgA Wealth Weighted Global Equities Index Strategy for institutional investors. It tracks the fundamentally weighted FTSE GWA Developed Index that was co-developed by U.K.-based Global Wealth Allocations and FTSE International. The index gives greater weightings to value-oriented companies with below-average price to earnings ratios.

Although State Street executives pointed to global interest in fundamentally weighted strategies, the firm has no immediate plans to debut fundamentally weighted strategies or ETFs in the U.S.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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