Investing: New index funds aren't always great

When you're investing, one of the easiest things to do is to run with your gut instinct. You smell money in Macy's? Buy! Your gut tells you the Federal Reserve is going to raise interest rates? Sell! Worried that Vladimir Putin will kill Italy just by staring at it? Sell!

Reams of academic studies, however, have shown that listening to those little voices in your head is about as helpful as giving in to your urge to burn things. In fact, the most sensible approach for most investors is the simplest: Buy a diversified selection of low-cost index funds, add to them regularly, and rebalance them from time to time.

Lately, though, the fund industry has been rolling out a number of index-fund variants — some of which may make sense, and others of which may not. Do you need them? In most cases, no. But it's worth looking at them before you get the urge to do something you shouldn't.

Your basic index fund boots the manager and selects its stocks (or bonds, or other securities) according to an index, such as the Standard and Poor's 500. Until recently, most stock indexes weighted their holdings according to the market value of the stock.

For example, the largest holding in the Vanguard 500 index fund (ticker: VFINX) is Apple, followed by ExxonMobil, and that's because the computer maker's current market value is $472.4 billion, vs. $409.2 billion for the multinational oil company. As each stock in the fund increases or decreases in value, it gets a bigger weighting in the fund. Among the cognisi, this is called a "cap-weighted" approach, short for "capitalization weighted," short for "ranked by the market value of the stock."

The problem with cap weighting is that as a stock gets more popular — and hence pricier — it becomes a larger percentage of an index fund's holdings. For example, the three largest holdings in the S&P 500 in 1999 were Microsoft, General Electric and Cisco Systems. Those stocks all remain below their Dec. 31, 1999, levels.

Over the years, and esp! ecially recently, fund companies have rolled out variants of index funds, all aimed at correcting the problems with cap-weighted funds. (Among the cognisi, these are called "smart beta" funds.) Among them:

• Equal-weighted funds. These funds simply give each stock in the index equal weighting, an approach that works best in a broad-based market rally, especially where small-company stocks outperform. The Guggenheim S&P 500 Equal Weight ETF (RSP) has gained an average 9.31% a year the past 10 years, vs. 7.39% for the Vanguard 500 Index fund.

• Rules-based funds. These indexes would give greater weight to stocks according to fundamentals, such as the amount of dividends paid out. WisdomTree LargeCap Dividend fund (DLN) has gained an average 20.92% a year the past five years, vs. 21.28% for the Vanguard 500 Index fund. (These are bull-market returns: Don't expect them the next five years.)

In short, the new index funds seek to beat the broad-based, cap-weighted indexes by doing something differently than the index: Emphasizing smaller-company stocks, for example, or a history of dividend payouts. That's no different than what active managers try to do, says Vanguard's senior investment strategist Joel Dickson. "We don't see these funds as an alternative to indexing, but rather a low-cost alternative to active management," he says.

And, as such, there's no harm in that. But you have to bear in mind that you're attempting to beat the index, something that stymied great minds for a long time. And, while certain strategies have had great success over many years, there's no Northwest Passage to superior stock returns.

For example, value investing is generally viewed as a way to get above-average returns. Value investors, such as Warren Buffett, look for cheap stocks, relative to earnings and hold them for the long term. And the Vanguard Value ETF (VTV) has indeed gained 7.47% a year the past decade, a hair more than the Vanguard 500 Index fund. But the Vanguard Growth Index! , which i! nvests in stocks with growing earnings, has beaten both, gaining an average 8.24%.

What's the harm in new index strategies? "The question should be turned on itself: What's the harm in cap-weighted indices," Dickson says. A company's market value represents the market's consensus on what the price of a stock should be. "If you believe that a sector of the market is mispriced, that's by definition active management."

The counterargument, of course, is that the components of the S&P 500 are chosen by Standard & Poor's, and that is, to some extent, active management. "There is a true statement there," Dickson says. "It's a committee-driven approach." But the index covers nearly all large-company stocks, and other large-company stock indexes track the S&P 500 fairly closely. And if you really want, you can choose a fund that chooses an even broader index — as the Vanguard Total stock Market fund (VTSMX) does.

For someone simply wanting exposure to the stock market at a very low price, then a broad-based index fund is a clear winner. In fact, if you want exposure to all the world's stocks, you could simply buy the Vanguard total World Stock index (VT) and knock off for the afternoon. Or you could mix and match a selection of diversified U.S. and international index funds, depending on your risk tolerance.

What if you hear a little voice urging you to try one of the new index funds? If that voice is telling you that it's way cheaper than a red-hot actively managed fund that charges 1.5% a year in expenses, well, that little voice probably has a pretty good idea. And if you're thinking that you'd like a fund that pays out above-average dividends because you need the income, then an index fund that focuses on rising dividends, such as the iShares S&P Dividend ETF (SDY), is a pretty good idea, too. Just don't listen to that little voice tell you to get into a staring match with Vladimir Putin.