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Understand Your Indexing Strategy

Tue, 15 Oct 2013

As so-called strategy indexes continue to rise in popularity, investors need to determine how well they fit with their portfolio plans and weigh the risks compared with traditional index funds, says Morningstar's Mike Rawson.

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Video Transcript

Christine Benz: Hi. I'm Christine Benz for Morningstar.com. Index funds have gained in popularity in recent years, but the product proliferation has, no doubt, left some investors feeling a little bit confused. Joining me to discuss some of the key issues related to index funds is Michael Rawson. He is a fund analyst with Morningstar.

Mike, thank you so much for being here.

Michael Rawson: Thanks for having me, Christine.

Benz: Mike, let's start by doing a little stage-setting. We've seen these dramatic inflows, especially into exchange-traded funds. Let's talk about what in your view is driving index funds' and ETFs' popularity.

Rawson: Right now about 27% of total assets in both mutual funds and index funds and ETFs is managed to an index. That's up from about 13% a decade ago. Certainly index funds have gained a lot of popularity over the past 10 years, and that's a trend we see continuing. I think what's driving that popularity is that index funds have a lot of the attributes that we look for when we look for a well-managed fund. Often they're low-cost. They tend to be moderate in terms of risk. They tend to have good diversification, and they tend to have low turnover. So these are some of the attributes we look for when we're looking for a good fund. Index funds generally have many of those attributes.

Benz: There has been a new category of what you call strategy index funds, strategy exchange-traded fund products. Let's talk about how these funds are different from traditional market-capitalization-weighted index funds and hat things people need to be aware of when they're looking at those sorts of products.

Rawson: So I think we're all familiar with a traditional index fund. These types of index funds have a lot of academic backing and theoretical support to them. The foundation for index fund investing, in general, is the efficient-market hypothesis. The efficient-market hypothesis is suggesting that it's very difficult for an active manager to consistently beat the market. That's based on the fact that we're going to invest in all the assets that are out there in the market in proportion to their market cap, so in proportion to their value. However, strategy funds, generally, will try to exploit some type of investment strategy. They may try to exploit a certain factor, such as value investing or momentum investing. So they tend to be a departure from what we think of when we think of traditional index fund investing.

Benz: Mike, it's not strictly black and white you say, that there is some gradation on that traditional index fund to strategy fund spectrum. Let's talk about how that gradation might play out in practice.

Rawson: When I think of the core part of my portfolio, I think of the market-cap-weighted passive index, traditional index funds. But as I move away from that, you start to get more and more into different types of strategies, and they often come under different names, whether it'd be alternative beta or fundamental indexing. And then you even have single-country or single-sector types of portfolios. As you move away from that market-cap-weighted index, it requires further research. It requires more research because those aren't buy-and-hold types of investments. Those are investments that could either be satellite holdings, which you could hold for an extended period of time or as supporting players in your portfolio, or they could be certain types of strategy which are only meant to be bought for short periods of time. Certainly, you think of leveraged and inverse funds as not being appropriate for a buy-and-hold investor at all. Those are really meant for day traders. Those may be index funds, but they're certainly strategy index funds, which you wouldn't want as part of your core part of your portfolio.

Benz: What kinds of things would you be looking for? I'm sure cost would figure in. What other sorts of things would one want to keep an eye on when evaluating one of these strategy-type products?

Rawson: Costs are, obviously, a main driver of performance. That's something Morningstar has found, and Morningstar has been a proponent of investing in lower-cost funds. A lot of these strategy funds tend to be higher-cost, so that's something you have to watch out for.

Benz: Why is that?

Rawson: I think one of the reasons why tend to be higher-cost is they tend to have fewer assets, so they don't have the economies of scale that a larger index fund is going to have. Also there has to be some kind of investment thesis or investment research that goes behind that strategy. That research is a little bit more costly to generate and to maintain. So those strategy funds are also going to have higher turnover. That's something you're going to want to evaluate when you evaluate the strategy: Is that turnover going to be so high that it's going to potentially lead to capital gains?

There are a whole host of things that you would want to examine before you would go into a strategy index fund as opposed to a traditional index fund. It's similar to the kind of approach you might follow if you were to evaluating an active manager: Do you agree with that strategy, is that strategy a good fit for your portfolio, and what are the attributes of that strategy? Is it higher-turnover? How is it going to affect the other assets in my portfolio?

Benz: Let's talk about risk, Mike, because I think sometimes people think mistakenly that index funds are lower-risk than actively managed products. How does risk play into an investor's evaluation of the appropriateness of an index product?

Rawson: A traditional index is really going to be a reflection of the asset class that you're investing in if it's market-cap-weighted. If you're investing in an equity index fund, it's still going to be riskier than a traditional bond fund. It's important to remember that just because it's an index fund doesn't mean that it's low-risk necessarily. There are a lot of higher-risk index funds. So it's important to remember that in different asset classes, the indexes are going to be a reflection of the risk of that asset class. Now, once you go into strategy indexes, those are potentially going to be a lot more or potentially less risky than the asset class. You'd want to evaluate what the risks of that strategy have been in the past and how that strategy correlates to existing funds in your portfolio.

Benz: So it sounds like as investors attempt to sort among different index funds and ETFs, you say pay attention to costs, pay attention to construction of the index itself, and also pay attention to what sorts of risks might lurk within that portfolio. Anything else that you would put on investors' shopping lists?

Rawson: Certainly. I think index funds in general have little bit of a halo effect because so many index funds have done well. We think of them as providing a fair rate of return, but not all of those modern indexes are going to give you a fair rate of return, so there has to be little bit more due diligence that you're going to have to do. So you have to dig a little bit deeper than just reading the name of the ETF or name of the index fund that you're investing in. You want to make sure that you understand the exact strategy it's invested in and how it's going to go about and deliver those expected returns to you, and if you think that's sustainable.

Benz: Mike, thank you so much for being here to share your insights. This is an increasingly popular category of an investment, so it's great to hear from you on this.

Rawson: Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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