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By Christine Benz and Michael Rawson, CFA | 09-23-2013 11:00 AM

Understand Your Indexing Strategy

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.

Christine Benz: Hi. I’m Christine Benz for 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.

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