Alternatives to the standard index fund

You’ve all heard of index investing, where you put your money in a mutual fund that doesn’t have a manager who chooses what stock, bond, or other security to buy. Rather, an index fund invests in a basket of investments that matches an index run by a third party. These indexes are designed to measure the economy or a section of the investment world.

By managing to an index, the mutual fund doesn’t have to pay for a top-notch manager, analysts, or really any research staff. Correspondingly, they are cheaper to run and those cost savings get passed on to you, the investor. They also can’t make a boo-boo. They can’t guess wrong. They can’t be over- weighted in the wrong thing or underweighted at the wrong time.

Of course, they also can’t beat the market (whatever market the index measures). But studies have shown that the average active fund manager doesn’t beat the market either. That should be surprising since the average manager is the market. By using index funds, you, the investor, are saying that you’re willing to give up the hope of beating the market in exchange for eliminating the chance of losing to it. At the same time, you save on expenses.

That’s not a bad compromise and millions of investors have embraced it. It’s responsible in no small part to the amazing growth of the newer Exchange-Traded Funds. As my regular readers know, I use both index and active funds in portfolios I manage, so I’ve fallen for it as well. But investors in general are a fickle lot and they began asking if there was a way to index AND beat the markets.

Well, yes and no. There are alternatives to the standard index fund, but they are still index funds. I’ll also argue that using them isn’t really about trying to beat “the market” but more about  selecting  different parts of the market to invest in. Whatever the semantics, let’s look at the two alternatives: equal-weighted and factor-based.

Most indexes are capitalization weighted. Equal-weighting has the fund invest in each security within the index equally rather than investing more money in the bigger companies. Studies show that equal-weighting tends to beat the normal indexes. This, however, should be no surprise. By not investing by size the equal-weighted holdings shift a bit smaller with a value (vs. growth) bias…both of which have proven in the past to have better returns than average.

Factor-based index investing takes one of the normal indexes and then adjusts the weighting of the individual holds by some factor. It might be dividend growth, price-to-sales ratios, profitability, momentum, or any of a myriad of other factors or combination of factors.

As always, the search for return has no single answer.

This article was published under the title "Standard index funds has options"

in the Wichita Falls Times Record News on December 22, 2013.