Capitalization-weighted index funds have been the most popular way to participate in the world of investing, thanks to John Bogle, the founder of Vanguard (Mutual Funds). Many other companies followed suit and index funds, such as the Spider (SPY) or Vanguard Total Market Index (VTI), have gained popularity by giving an investor a broad-based investment exposure and diversification with a single purchase. These products, known as exchange traded funds or ETFs, are gaining favor rapidly.
Market-cap-weighted ETFs give a larger percentage of holding to the large stocks. Mega-cap companies, such as General Electric, Bank of America, Exxon Mobil and Microsoft, usually are in the top holdings of ETFs focusing on market capitalization. As companies rise in price, so do their market caps and so do their weightings within the fund. This is a system that takes the emotion out of stock selection, which in my opinion, is why it works so well. Any system that removes fear and greed from investment-decision making is the most important aspect of portfolio performance.
There are, however, different indexing strategies or systems that will possibly outperform themarket-cap-weighted ETFs. Several historians have proved that, using data from the trailing 30 years of market returns, small capitalization stocks outperform large over the long run. Further, it is noted that low PE stocks, i.e., stocks with low price to earnings ratios, outperform stocks with high PE ratios over the long run. Recently, the market has been flooded with new ETF releases, some of which are very good and are using historical data to create different quantitative formulas to try to outperform the market-cap-weighted indices.
I am intrigued by ETFs that are structured by focusing on the fundamentals of a company. Fundamentals such as earnings and dividends are now the primary factors used to form an index. The PowerShares family of ETFs focus exclusively on many fundamental characteristics to form an “intellidex.” PowerShares ETFs, therefore, give more exposure to mid- and small-capitalization companies, and leaves out companies with poor earnings and fundamentals. Market-cap-weighted ETFs have gained so much in popularity they have surpassed the $5 trillionmark in assets. There are, however, a couple of index funds I have researched and, in my opinion, should continue to beat the S&P 500 index over the next five years.
WisdomTree Dividend Top 100 Fund
Dividend-paying stocks lagged the S&P 500 index in both 2004 and 2005, but really began to lead the market in 2006. This trend should continue over the next few years. Income from common stock dividends are currently taxed at 15 percent, regardless of your tax bracket. High-income earners are usually major players in the investment world, so I would take a look at the WisdomTree Dividend Top 100 fund (DTN). It is an index fund that holds 100 of the highest dividend-paying stocks traded on the New York Stock Exchange. It carried a 0.38 percent expense ratio and paid a 3.32 percent dividend as of May 31, 2007.
PowerShares Water Resources Portfolio
We all know that water is the most plentiful commodity on earth. But with the planet’s rapidly growing population of six billion, supplies of water on a per capita basis are diminishing rapidly. Only 20 percent of the world’s population has access to running water. And, only one-third of the world’s population has access to clean water. Many companies will benefit from the “blue gold rush,” some of which include pump and filter manufacturers, water utilities and irrigation equipment manufacturers. It is hard to select the companies that will ultimately dominate this sector, so I recommend buying the PowerShares Water Resources Portfolio (PHO). This ETF is a diversified way to participate in the “blue gold rush” in the coming years, giving an investor exposure to small-, mid- and large-capitalization stocks in the water sector.
Both these ETFs are poised to move higher over the long run. Both are fundamentally weighted ETFs and are great examples of a paradigm shift that will begin to gain more popularity in the years to come.
Ben Stewart is the President of Stewart Wealth Management Inc., a Marin County-based Registered Investment Advisory firm that specializes in financial solutions and money management for small business owners and high, net-worth families. He can be reached at
ben@stewartwealthmgt.com; 415-464-4920,
or visit his website at
stewartwealthmgt.com.
