Can You Beat the Market…With Index Funds?

June 19, 2014

Last week, I wrote about different types of index funds and how some “index funds” aren’t as diversified or as low cost as they may seem. However, there’s also a case for certain types of diversified index funds that are designed to outperform traditional index funds. They come in two flavors: equal weight and fundamental index funds.

The idea behind equal weight index funds is to have each stock in the index represented equally to eliminate the “bias” of traditional index funds towards the largest capitalization stocks. That’s because traditional index funds are weighted in proportion to the value of each stock so if a stock rises in price relative to the rest of the index, the stock will make up a larger proportion of the index. Fans of the equal weight approach argue that traditional index funds are more likely to be affected by overvalued stocks are too heavily skewed towards the largest companies. Since small companies have tended to outperform larger ones in the long run, equal weighted index funds can also benefit by having more in smaller stocks.

With fundamental indexes, instead of having each stock weighted equally, the stocks are weighted according to other measures like dividends, earnings, or a combination of factors. In addition to eliminating the bias towards large stocks, this can also tilt the index towards value over growth stocks and allow investors to benefit from the fact that value stocks have tended to outperform growth stocks in the long run. With so many possible variations, the numbers of these funds have proliferated with offerings from Powershares, Wisdomtree, and even traditional index fund companies like Blackrock, Vanguard, and State Street.

On the plus side, these funds have often outperformed traditional index funds although they haven’t been around that long and the out-performance hasn’t always been consistent. On the negative side, they do tend to have higher fees and generate more taxes. Whether the benefits outweigh the costs in the long run is yet to be seen but they can be a lower cost way of trying to outperform the traditional indexes.