PWC Earns Five Stars

July 02, 2006

The Old Indexing Is Bad Argument

To investors who have been following the "fundamental indexing" argument, Amex's rationale for the Intellidexes will sound familiar. Traditional indexes were designed as benchmarks, not as the platform for investable products. As such, they make many common mistakes, such as:

  • Lack of diversification: In the S&P 500, for instance, 2 percent of the stocks make up 20 percent of the index.
  • No valuation component: Market-cap-weighted indexes, by definition, over-invest in overvalued companies and under-invest in undervalued companies.
  • Representation: Market-cap weighted indexes, according to this argument, add companies when they're "hot" and end up overweighting the wrong sectors, like Internet stocks in the 1990s or REITs in 2003.

So how does the Intellidex correct all these? It uses "25 different criteria selected based on historical usefulness in explaining subsequent stock returns." In others words, it hopes that past performance will explain future success.

It looks at the 2,000 largest stocks in the market and ranks them by a series of measures. The 25 components fall into four buckets: Valuation, Fundamentals, Timeliness and Risk. The first three categories each contribute about 28 percent to the final determination, and Risk counts for 15 percent.

The system uses a complicated weighting methodology that aims to keep the index breakdown in line with the size/sector breakdown of the broader market, without any one name dominating the space.

One of the more common arguments against the Intellidexes is that they gain their outperformance by overweighting small-cap names. But according to Altavista, the indexes (with the benefit of hindsight) have actually outperformed all three S&P capitalization segments over the past 10 years.

Unfortunately for PowerShares, the real-life results aren't so good. As of January, the fund was indeed outperforming all three S&P benchmarks. But over the past six months it has fallen behind the S&P 400 MidCap and S&P 600 MidCap, and now trails those two funds slightly since inception. In fact, it's barely tracked the S&P 500 in 2006.

Should that make me worried? Should I get ready to sell?

To be honest, I don't know. The truth is that simply sticking with the small and mid-cap indexes over the past few years is quite a feat considering PWC's large-cap tilt. Small and mid-caps have crushed large caps over the past three years, and for any large-cap fund to hang with the small and mid-cap indexes is an impressive performance.

I only wish the Altavista research paper went into more depth to explain how the fund achieves this performance. The paper calls out a couple of factors, including P/E ratios and futures growth estimates. And it makes a big deal about the relationship between return-on-equity (ROE) and price-to-book value (P/BV). PWC, it says, has a much higher ROE than the S&P 1500 (18.2% vs. 16.4%), suggesting that PWC's companies earn a higher-than-average return on their investment. At the same time, PWC is trading at the same P/BV as the S&P 1500, suggesting that investors don't have to pay any more to gain access to that investment return.

I guess that's a start. But I need more. It's fine to talk about "timeliness," but if we all knew when it was "timely" to buy stocks, we wouldn't need index funds in the first place, would we?

My worry with my PowerShares investment is two-fold. First, I worry that it may fall victim to some unimagined skew - for instance, that the fund might trail the market if and when growth stocsk returns to the fore. PowerShares says that isn't the case, but we don't have the facts laid out in front of us.

Secondly, I worry that I'll simply lose faith. If PWC trails the market for a few months, I might look at that 60 basis point expense ratio and wonder: What have you done for me lately? And that means I'll probably jettison the fund just at the wrong time.

Here's hoping that never happens. Here's hoping that the Intellidex has found that sweet spot in the market where it can manage to outperform for the long haul. It seems so unlikely … but in the meantime, I'm going to enjoy the ride.

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