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Custom index funds

Chris Farrell Dec 16, 2009

Question: A couple of years ago, I heard a financial analyst on a radio show talk about index funds weighted on the basis of dividends paid. But I have not been able to find such a fund, and the representatives at the institutions where I invest said no such fund exists. Is there an index-type fund based on dividend offerings, or a low-fee managed fund that offers a wide-based selection of companies that offer dividends? Robert, Rutherford, NJ

Answer: No, you heard right. There has been a new generation of custom equity indexes created in recent years. Among the leading lights are quant guru Robert Arnott of Research Associates and Jeremy Siegel of Wharton University. These indexes are typically marketed as Exchange Traded Funds (ETFs) and among the companies that market them are Powershares and Wisdom Tree Investments. You can research the ETFs at the market-data firm Morningstar.com.

A brief definition: The difference between the traditional equity indexes and the new breed of equity indexes is all about how the indexes are constructed. For instance, the S&P 500, the Russell 1000, and other well-known traditional indexes are weighted by “market-capitalization.” That means the impact of each stock in the index is relative to the total market value of its shares. In practice the companies that are overvalued wield a disproportionate influence on performance on the way up and on the way down. Market cap indexes are vulnerable to market booms and busts. (I’m not convinced its all that big an effect, but that’s the criticism.)

The new indexes argue that they reflect the dynamics of Main Street more than the moods of Wall Street. They reduce the impact of Mr. Market’s manic moods by creating indexes from fundamental factors, such as earnings, revenues, dividends, and book value. This type of cap-indifferent index is less susceptible to investor manic mood swings, and comes closer to ranking companies on their importance to Main Street. But the fees charged to owners can be higher compared to traditional indexes.

My bottom line? Investors come out ahead whether they invest in the traditional or new-fangled indexes. Individual investors have one more reason not to turn their money over to active money managers. Both theory and practice say active management costs a lot more than either index type–for poorer performance.

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