Indexing

[rffrydr]

To carry on a theme of mine the separation of value from what is valued: the full faith and credit in indexing is showing some fraying on the...core:

[rffrydr]

Built--in 1.5% headwind on the Russell. Again Market Cap issue:

WSJ June '06

THE POPULAR Russell stock indexes are about to be rebalanced -- and that may be costly to index-fund investors.

On June 16, Russell Investment Group, a subsidiary of Northwestern Mutual Life Insurance Co., will publish a list of stocks likely to enter or exit its indexes at the end of this month, as it does each year. Index funds tracking Russell's benchmarks must adjust their holdings to mirror the rebalanced indexes. But professional traders often scoop up shares of companies likely to be added in advance, hoping to sell them to index funds a few weeks later at higher prices. These trades can take a bite out of the funds' returns.

With about $3.8 trillion benchmarked against Russell indexes, including $793 billion in retail mutual funds, there will be significant demand for any stock on Russell's list of likely index additions. Professional investors try to anticipate which stocks will be added months in advance of the rebalancing, hoping to take advantage of that demand.

Russell has taken a number of steps in recent years to try to level the playing field -- for example, by adding newly public companies to the indexes throughout the year. Some strategists say those measures are working to make the annual reconstitution less damaging for index funds. Even so, many advisers say individual investors should look for index funds that track benchmarks that aren't as popular or predictable as the Russell indexes, since these funds may be less affected by active traders.

Membership in the Russell indexes is largely determined by "market capitalization," or a company's share price multiplied by the number of shares outstanding. The largest 1,000 stocks by market cap, for example, go into the Russell 1000, while the next 2,000 largest comprise the small-cap Russell 2000. Since market values change constantly, the companies that fit Russell's criteria also change.

Russell's straightforward rules allow rapid traders to snap up stocks before they're added to the index. A study to be published in a coming issue of the Financial Analysts Journal suggests that those trades are quite costly to Russell 2000-tracking index funds. Active traders reduced these funds' annual returns by 1.3 to 1.84 percentage points between 1990 and 2002, according to the study, which was conducted by researchers at the University of Central Florida; the University of Washington, Tacoma; and Virginia Tech. "Russell needs to make their process less transparent," says Vijay Singal, a Virginia Tech finance professor and co-author of the study.

Russell says it has implemented a number of changes in recent years to damp the reconstitution's impact on index funds. This year, for example, Russell won't replace any companies that drop off the list of likely additions during June because of corporate actions such as mergers. And in 2004, Russell started adding newly public companies to the indexes each quarter instead of just once a year.

While active traders once had a perception "that there was some kind of free lunch" in the annual Russell changes, that's no longer the case, says Lori Richards, director of client service for Russell indexes. "Index funds aren't sitting there waiting to be taken advantage of," Ms. Richards says.

Many strategists expect that overall, the Russell indexes' turnover will be slightly lower this year than in previous years, partly because Russell has been adding IPOs to the indexes throughout the year. Some of the indexes may still see many additions and deletions, however. A recent report by Citigroup Inc. estimated that the Russell 2000 index will have turnover of 42% from this month's rebalancing, significantly higher than last year, partly because many small-cap stocks have performed well and will graduate to the large-cap Russell 1000.

Firms that run Russell index-tracking mutual funds say that there is always some cost associated with index rebalancing, but that they prepare for it months in advance. "We . . . use all the tools at our disposal" to make things difficult for people "who might want to front-run us or game the index changes," says Steven Schoenfeld, chief investment strategist for global quantitative management at Northern Trust Corp., which runs retail and institutional Russell index funds.

But funds are often reluctant to diverge far from their underlying index, making it hard for many fund managers to defend themselves against the active traders, says Virginia Tech's Mr. Singal.

While any index fund can be hurt by active traders attempting to profit from index changes, investors may be able to find funds that are less likely to fall prey to such trades, advisers say.

One strategy: Look for funds based on less-popular indexes. The billions of dollars tracking the Russell indexes make them a prime target for active traders. Less-popular indexes "attract fewer front- runners and therefore should have less of a performance drag when they reconstitute," says Sonya Morris, an analyst at investment-research firm Morningstar Inc. Just a handful of index funds, for example, track certain Morgan Stanley Capital International and Dow Jones Wilshire indexes. (Dow Jones & Co. is the publisher of The Wall Street Journal.)

Investors now have greater access to these and other less widely followed indexes, thanks in part to the proliferation of exchange- traded funds, which resemble traditional mutual funds but trade on an exchange like a stock. Late last year, for example, State Street Corp. launched a number of ETFs tracking large-, mid- and small-cap Dow Jones Wilshire indexes. In 2003, indexing giant Vanguard Group switched its Small-Cap Index fund from the Russell 2000 to the MSCI US Small Cap 1750 Index, partly because it believed the MSCI index was less likely to attract traders attempting to profit from index changes.

Investors might also consider indexes that are less predictable, says Virginia Tech's Mr. Singal. At Standard & Poor's, for example, index additions are chosen by a committee of economists and analysts instead of by a strict formula.[/quote]
_________________
Today is the Tomorrow you worried about Yesterday!

[rffrydr]

The guiding light of Subprimeland, the ABX indices, separate but equal:

"... The ABX and MBS tranches don't directly reference or differentiate borrowers perceived to be higher or lower risk. They are all in one pool, the securities just distinguish which group of investors bears the first loss, second loss and so on. I think the ABX represents more of a macro call by investors on the general level of stress in the subprime end of the market. Its more analogous to the VIX."

housing derivatives CME housing futures hedging case-shiller index
_________________
Today is the Tomorrow you worried about Yesterday!

[rffrydr]

What it is:

WSJ

Index-fund investors, known to take a hands-off approach to their money, are now being asked to make some big decisions -- and possibly take on more risk.

Index funds traditionally have aimed to mirror the performance of broad-market benchmarks, such as the Standard & Poor's 500-stock index or the Dow Jones Wilshire 5000 Composite index. This made the funds relatively predictable, since investors could expect to closely track the market's return, minus a small slice for management expenses. Another attraction: Index funds have historically outperformed the majority of funds that rely on a fund manager's active stock picking.

Now, however, investors are embracing a slew of new specialized funds that have exploded the idea of what an index fund is meant to track. Fund companies, aiming to differentiate their offerings and levy higher fees, are slicing and dicing the market in various new ways. Many of these "alternative" index funds are less than a year old and have yet to establish a meaningful track record.

Some firms are even inventing new indexes to track. WisdomTree Investments Inc. offers dozens of exchange-traded funds -- essentially, mutual funds that trade like stocks -- that track indexes composed of dividend-paying stocks. (Generally, the bigger the dividend, the more weighting the stock has in the index.) VTL Associates LLC is planning to launch three ETFs that track indexes weighted by the size of company revenues. That's a big departure from traditional indexing, which weights stocks based on their so-called market capitalization, or total stock-market value.

Other funds target indexes focused on narrow market niches, including the newly launched PowerShares Buyback Achievers Portfolio, an exchange-traded fund that invests in companies buying back their own shares, and the Claymore/Ocean Tomo Patent ETF, which buys stocks of companies based on the value of their patents.

Yet many financial advisers and industry experts fear that the alternative index funds sacrifice many of the traditional benefits of indexing, including low cost, broad diversification and simplicity. Experts also see risks to investors in many of the new funds that track narrow, volatile market segments, such as commodities and currencies. Some funds employ complex financial products such as derivatives, or use borrowed money, which can juice returns on the upside but also amplify downturns.

Fees are also an issue. Many offerings from WisdomTree and PowerShares Capital Management, another major seller of alternative index funds, charge expenses of roughly 0.5% to 0.6% of assets. While that makes them cheaper than many actively managed mutual funds, they are more expensive than some traditional index funds, such as those offered by Vanguard Group and Fidelity Investments, which charge as little as 0.1% to 0.2%.

"Investors should not just buy into [alternative index funds] thinking they're getting the passive replication and low costs and longer-term outperformance of indexes," says Srikant Dash, an index strategist at Standard & Poor's, who has developed both market-cap- weighted indexes and newer alternative indexes.

As the world of index investing grows more complex, financial- services firms are rolling out new types of accounts, with minimum investments of $25,000 or more, to help high-end investors make sense of it all. For an added fee, typically 1% of assets or more, firms including A.G. Edwards Inc. and Citigroup Inc.'s Smith Barney brokerage unit will help you build a diversified portfolio using only index-tracking investments.

Interest in indexing has soared in recent years, thanks in large part to its popularity in retirement plans and among hedge funds. Assets in index mutual funds and exchange-traded funds accounted for 14% of the roughly $7.3 trillion in long-term mutual-fund and ETF assets as of November, up from 9% at the end of 2000, according to Financial Research Corp.

New and narrowly focused index funds are drawing much of the new money. Among the 10 ETFs taking in the most money in 2006 are iShares FTSE/Xinhua China 25 Index and iShares MSCI Brazil Index, according to fund-tracker AMG Data Services.

Many alternative index funds aim to solve what their proponents say is a basic problem with market-cap weighting. As a stock's price climbs, market-cap-weighted funds must buy more shares, forcing them to overweight overvalued stocks and underweight underpriced shares, critics say. Providers of alternatively weighted indexes say they can shelter investors from market bubbles and their ugly aftermath, and get better returns. Index strategies "don't have to be market clones," says Robert Arnott, chairman of Research Affiliates LLC, which offers indexes based on a variety of company fundamentals, including revenues and dividends.

One alternative is to weight all the stocks in an index equally. Morgan Stanley, for instance, offers an S&P 500 fund that gives each stock equal representation instead of weighting holdings based on market capitalization. Over the past five years, class A shares of the Morgan Stanley Equally-Weighted S&P 500 fund, which charge 0.63% in fees, delivered annualized returns of 10.9%, beating the traditional market-cap-weighted S&P by more than four percentage points. Rydex Investments recently launched nine equal-weighted ETFs focused on various market sectors. Other equally-weighted ETFs include KBW Regional Banking and First Trust Portfolios LP's Nasdaq-100 Equal Weighted Index.

But investors need to understand the bets they're taking with such funds, advisers say. "With equal weight, you're really just dialing up the small-cap factor," says David Yeske, a financial planner in San Francisco. While small-cap stocks have outperformed large companies in recent years, there's no guarantee they'll do so in the future.

What's more, equal-weighted funds may come with higher expenses and less tax efficiency than traditional index funds. As stocks' prices change, their weighting in cap-weighted indexes generally remains the same, so little trading is required. But equal-weighted indexes must trade more as stock prices move, which drives up transaction costs. More trading also increases the potential for a fund to run up capital gains, which can saddle investors with a tax bill.

Advocates of alternative indexing often can't agree on the best way to index. WisdomTree's new LargeCap Dividend ETF, for example, tracks the firm's own WisdomTree LargeCap Dividend Index, made up of the 300 largest dividend-paying U.S. companies by market cap. Each company's weight in the index is based on the size of its dividend, with the biggest weightings going to Citigroup, General Electric Co. and Bank of America Corp.

While companies can manipulate earnings and other fundamental measures, "there's no debate about how much the dividend is," says Jeremy Siegel, a finance professor at the University of Pennsylvania's Wharton School and WisdomTree's senior investment strategy adviser.

The problem, counters Research Affiliates' Mr. Arnott, is that most U.S. companies don't pay dividends, and those that do are concentrated in a few sectors like financials and utilities. A dividend-weighted U.S. stock index isn't truly a broad market index, he says.

Meanwhile, brokerage firms are launching accounts to help customers navigate the more-complex world of index funds. TD Ameritrade Holding Corp. late last year launched Guided Amerivest, an account that helps clients with a minimum $50,000 build ETF portfolios for an asset-based fee of 0.65% to 0.8%, not including expenses of the underlying holdings. A.G. Edwards has several new types of fee-based, or "wrap," accounts constructed entirely of ETFs.

For individuals investing $25,000, A.G. Edwards charges 1.5% to 2.25% of assets annually for an ETF wrap account. Smith Barney offers an ETF wrap account, for a minimum of $25,000, that charges expenses of 1% to 1.5%. The accounts help investors choose index funds, allocate money among them and periodically rebalance holdings.

Some firms will help wealthier investors construct a customized index, using individual stocks and rejiggering some of the holdings. Northern Trust Corp. and Wilmington Trust Corp. have both launched such accounts using fundamentally-weighted indexes in recent months.

But some of these accounts might only approximate an index's result, because they aim to replicate an index by buying just a few of its constituents. In a $100,000 account tracking the S&P 500, for example, index-based managed account specialist Active Investment Advisors will typically hold just 50 stocks, say Curt Overway, the firm's president. The returns of such an account may deviate from the index's returns by as much as 4 or 5 percentage points annually, though the performance difference is very small over a 20-year period, Mr. Overway says.

"You take a horrible risk of underperforming" when you hold a small sample of the full index, says William Bernstein, author of "The Four Pillars of Investing." Such an account is likely to eliminate some of the top-performing stocks in the S&P, causing it to substantially lag the index over time, Mr. Bernstein says.

---

Beyond the S&P 500

New index-tracking funds are redefining the category:

-- Some of the funds track narrow slivers of the market, while others weight stocks differently than traditional index funds do.

-- Proponents say the new funds give investors more choices, and, in some cases, correct biases of traditional products.

-- Critics of the funds charge that they expose investors to more risks and higher fees. ---

Corrections & Amplifications



THE WEIGHTINGS of stocks in market-cap-weighted index funds are automatically adjusted to reflect their index weightings as stock prices change. A Personal Journal article Tuesday incorrectly said that market-cap-weighted index funds are forced to buy more shares of a stock as its price climbs.

(WSJ Feb. 2, 2007)
_________________
Today is the Tomorrow you worried about Yesterday!