September 2009 Mutual Fund Red Flags

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

Red Flags is designed to alert you to funds' hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured is a sell, and in fact some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.

Is your fundamental index fund an overpriced value fund in disguise?

Index funds and exchange-traded funds based on various "fundamental indexes" have been around for a while now. In 2005, PIMCO launched a fundamental index fund subadvised by Research Affiliates' Robert Arnott and, soon after, WisdomTree launched ETFs that weighted stocks based on their dividends and earnings. This was innovative at the time as most of the prominent equity indexes then, including the S&P 500, were capitalization-weighted. Now, with a few years worth of real-world performance data for funds that utilize a fundamental strategy, we can see how they have performed versus traditional indexes and discuss how investors can use them.

According to fundamental indexing's proponents, cap-weighted indexes suffer from a flaw, even if one believes the market is relatively efficient in correctly pricing publicly traded securities over the long haul. They argue traditional indexes systematically overweight overvalued stocks and underweight undervalued stocks. A relevant example would be Sun Microsystems' JAVA stock near the top of the Internet bubble ($250 in July 2000 versus about $10 a share now) and Procter & Gamble's PG stock (which went from $28 to $52 a share during the same period). Sun had a market cap of almost $90 billion supported by net income of $1.8 billion in 2000, while P&G had a similar market cap ($101 billion) but was supported by almost twice the net income ($3.5 billion). The market valued the firms about the same because it forecast not just that Sun would grow earnings faster than P&G but that this higher growth rate would actually add value to the firm. The expectation was widely off base on both accounts. While a cap-weighted index would have had the same amount of assets in each stock, a fundamental index based on earnings, dividends, or book value would have had a much larger weighting in P&G. And fundamental indexers point out that their strategy should outperform during various market environments, not just bubbles.

Looking Beyond the Spin
Paul Kaplan, vice president of quantitative research at Morningstar, has studied the subject and he wrote an award-winning paper in 2008 criticizing this promise of predictable outperformance. Notably, Kaplan showed that rather than having a clear theory, proponents of fundamental indexing "have only a conjecture that market-valuation errors are more variable than fair-value multiples." In essence, in order for fundamental indexing to work, the market has to systematically overprice securities as much as it underprices securities. In addition, Kaplan, like other researchers, has attributed much of the outperformance to the "value effect"--that is, that the indexes are biased toward value, and value has outperformed the market in this decade.

A Black Eye in 2008
Kaplan wrote his paper in the beginning of 2008, and by the end of the year, many of his concerns were realized. The S&P 500 lost 37%, the WisdomTree ETFs lost a similar amount, and PIMCO Fundamental IndexPLUS PIXAX lost even more because of its bond strategy overlay difficulties. True to Kaplan's expectation, each fund performed very much like a largecap value index. Longer term, none of the funds has outperformed a comparable value index by much. From 2006 through August 2009, WisdomTree Total Dividend DTD has lost 6.26% annualized compared with a 7.05% loss for iShares Russell 3000 Value Index IWW.

Proper Expectations
Fundamental index funds are not a silver bullet. Research and experience now show that they not only have risks and returns that are similar to value-biased cap-weighted value indexes but they come with expense ratios that can be twice as much, too. Because they are really just value indexes, you should compare them with other value index funds and plan on similar performance.

Ryan Leggio is a mutual fund analyst with Morningstar.