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A new spin on stock-index funds

Exchange-traded funds (ETFs) combine with alternate ways to index stocks to create a diversification tool.

By Janice FioravanteCorrespondent of The Christian Science Monitor / August 20, 2007

You thought indexes were a no-brainer, right? You buy a stock-index fund that mimics, say, the S&P 500 and you know you've got a fund with low costs that often beats the gains of many money managers. But indexing has gotten quite a bit more involved.

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Not only have new ways of indexing been devised, but almost daily new exchange-traded funds (ETFs) based on these indexes are made available to investors. ETFs, which are like mutual funds in concept but trade on exchanges like stocks, offer alternatives and enhancements to traditional index funds. Some index-fund investors are hoping that because of the way their funds are constituted, they won't tumble as easily as traditional index funds have in this rocky market.

The Standard & Poor's 500 index is based on market capitalization. It takes its largest positions in the largest valued companies, and as the stocks of those companies rise and fall, so does the index. The value of the stocks in the S&P index is calculated by multiplying their quoted price by the number of shares outstanding. This method favors large cap and growth stocks.

Instead of market capitalization, nontraditional indexing uses alternative strategies to weight holdings. These newer indexes tend to lean toward small caps and value stocks. For the past seven or eight years, the market has favored that particular mix, so none of these newer indexes (the oldest of which began in 2003) have really been tested in changing markets – until now.

Sonya Morris, editor of the Morningstar ETF Investor, agrees that many ETFs based on these alternatively weighted indexes emphasize smaller stocks and so do well when small caps are in favor. But analysis shows that the biggest stocks boast the most attractive valuations now, she says, so she's drawn to traditional market-cap weighted benchmarks because they lean toward bigger stocks.

"The gradation is leaning to big blue-chip stocks – megacap ETFs," Ms. Morris says.

This points back to the advice often given investors: diversification and asset allocation. Consider these alternatively weighted indexes and their respective ETFs as more choices to have in your repertoire of investments.

An early index that veered from the market cap S&P 500 was the S&P Equal Weight Index, developed by S&P and Rydex Investments. The Rydex S&P Equal Weight ETF was the first

product benchmarked to the index. The S&P Equal Weight Index gives every stock in the index the same weight. The thinking behind this and other alternative indexes is to broaden exposure.

"In the S&P 500, 65 to 70 percent of the holdings are the 100 largest stocks," says Tim Meyer, ETF Business Manager at Rydex Investments. "The new concepts offer exposure to value and smaller caps."

The equal weight strategy has worked well, as smaller-cap stocks have been posting better returns. "For the 4-1/2 years it's been available, the Rydex S&P Equal Weight ETF has outperformed the S&P 500," says Mr. Meyer. From its start in 2003 through June 2007, the index is up 19.63 percent, versus 14.73 percent for the S&P 500, he notes. That's why he sees it as a good way to diversify. "It's a great complement to the S&P 500," he says.

But with this new strategy comes higher management fees: The fund needs to be rebalanced every quarter to keep each stock equally weighted. This turnover drives transaction costs up and can trigger taxes from capital gains. But still, compared with actively managed funds, the fees are lower.