Indexing:
The Good,
The Bad,
And the Ugly
Part 1:
The Good
U.S. Equity Index Funds as a Percentage of
U.S. Equity Mutual Fund Assets
13
8.2
6.6
5.2
8.9
9
9.8
10.6
11
11.3 11.1 11.2 11.5
13.7
14.5
Net Flows to US Index Funds ($ Billions)
70
61
62
60
5
46
50
40
35
2
1
25
30
2
1
20
10
5
22
30
56
2
17
40
35
35
2
26
54
27
21
18
2 7
2 6
25
2
2 8 1 7
2
39
17
28
17
28
8
11
4
11
28
31
19
25
14
14
-6
-10
Global/International Equity
24
10
8
8
31
27
33
0
Domestic Equity
58
Bond and Hybrid
Net Assets vs. Number of ETFs ($ Billions)
1200
1000
101
Total Net Assets of US Registered ETFs
800
75
Total Net Assets of US Non-Registered ETFs
600
29
36
15
400
1
200
0
Number
of ETFs
5
296
580
408
891
703
496
66
83
102
151
226
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
80
102
113
119
152
204
359
629
728
797
923
The Good:
 They’re cheap.
 Sometimes, markets actually are efficient.
Active Management’s Dirty Little Secret
Percentage of Funds Outperformed by Benchmarks
Type
Benchmark
1 year 3 year 5 year
All Domestic Equity Funds
S&P Composite 1500
49.31 51.68 57.63
All Large Cap Funds
S&P 500
65.72 57.65 61.83
All Mid Cap Funds
S&P MidCap 400
73.75
83.9 78.19
All Small Cap Funds
S&P SmallCap 600
53.42 70.11 63.02
All Multi Cap Funds
S&P Composite 1500
63.9 60.84 66.28
Not Just an Equity Phenomenon
Percentage of Funds Outperformed by Benchmarks
Type
Benchmark
1 year 3 year 5 year
Government Long Funds
Barclays Long Government
94.12 65.96 68.18
Government Intermediate Funds
Barclays Intermediate Government
68.29 58.7 68.09
Government Short Funds
Barclays 1-3 Year Government
56.82 58.7 75
Investment-Grade Long Funds
Barclays Long Government/Credit
76.15 72.73 69.79
Investment-Grade Intermediate Funds Barclays Intermediate Government/Credit
30 44.59 55.75
Investment-Grade Short Funds
Barclays 1-3 Year Government/Credit
60.26 96.39 97.14
Indexed Funds vs. Actively Managed:
1.4
1.3
1.2
1.1
1
PQY
PWZ
SPY
0.9
0.8
Part 2:
The Bad
Types of Indexes:
 “Plain Vanilla” – Market Cap/Market Cap
 Equal Weighted
 Fundamentally selected and/or weighted
 “Proprietary” – Opaque methodology
Market-Cap Weighting…
…works well when…
 Large cap outperforms
 Growth outperforms
 Bubbles form
but falters when…
 Small cap outperforms
 Value outperforms
 Bubbles burst
Equal Weighting…
…works well when…
 Small cap outperforms
 Bubbles burst
 Sector over-weights outperform
but falters when…
 Large cap outperforms
 Bubbles form
 Sector underweights underperform
Fundamental Weighting…
…works well when…



Small cap outperforms
Value outperforms
Bubbles burst
but falters when…
 Large cap outperforms
 Growth outperforms
 Bubbles form
Proprietary Indexes…
Falter when…
 Small cap outperforms
 Value outperforms
 Bubbles burst
Nasdaq 100 in Depth:
Restructuring Occurs When:
 Any security’s weight surpasses 24%
or
 The aggregate of positions of more than 4.5%
is greater than 48%
or (apparently)
 Nasdaq feels like it
How the Rebalance (is supposed to) Works:
 Weights of all stocks that are > 1% of the
index are reduced in tandem until the offense
is cleared up
 The pool of weight is then redistributed, issue
by issue, to those stocks under 1% of the
index
In other words “we wish we’d made this
index equal weighted to begin with.”
How the Rebalance Did Work (4/29/2011):
Ticker
Weight Shift
AAPL
MSFT
-8.16%
4.91%
ORCL
INTC
CSCO
GOOG
3.36%
2.45%
2.10%
1.59%
QCOM
-1.52%
What’s Wrong with the S&P 500:
Why Committees Aren’t Great:
▪ Human discretion instead of Rules based
decision making
▪ Present uncertainty around rebalance and
inclusions, decreasing market efficiencies
▪ Possible conflicts of interest
Does Type Matter?
1.75
Nasdaq 100
Russell 1000
1.5
Russell 1000 Equal Weighted
FTSE-RAFI 1000
S&P 500
1.25
1
0.75
0.5
8/18/2006
8/18/2007
8/18/2008
8/18/2009
8/18/2010
8/18/2011
Does Type Matter?: Top 5 Holdings
Russell 1000
Exxon Mobil Corp
Apple Inc
Intl Business Machines Corp
Chevron Corp
Microsoft Corp
Total:
2.95%
2.85%
1.67%
1.58%
1.54%
10.59%
S&P 500
Exxon Mobil Corp
Apple Inc.
Intl Business Machines Corp
Chevron Corp
Microsoft Corp
Total:
FTSE RAFI 1000
Exxon Mobil Corp.
3.00%
AT&T Inc.
2.59%
Chevron Corp.
1.97%
General Electric Co.
1.92%
Wal-Mart Stores Inc.
1.75%
Total: 11.24%
Nasdaq 100
3.35%
3.24%
1.90%
1.80%
1.75%
12.04%
Apple Inc.
Microsoft Corp.
Google Inc. Cl A
Oracle Corp.
Intel Corp.
14.79%
9.08%
5.58%
5.57%
4.57%
Total: 39.59%
Part 3:
The Ugly
Core Problems with Commodities Indexes:
What’s the Market Cap of Wheat?
Which “Oil” Do You Buy?
Four Main Commodities Indexes:
DJCI
CRB
GSCI
3%
Rogers
8%
14%
7%
22%
67%
35%
44%
How Do They Stack Up?
1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
DJ-UBS
CRB
Rogers
GSCI
J-11
J-11
M-11
A-11
M-11
F-11
J-11
D-10
N-10
O-10
S-10
A-10
J-10
J-10
M-10
A-10
M-10
F-10
J-10
D-09
N-09
O-09
S-09
A-09
Structure Matters
250
200
Spot Natural Gas
Front Month Index (UNG)
150
100
50
0
Patching the Holes:
Better Natural Gas?
140
120
Front Month Index (UNG)
100
12 Month Strip (UNL)
80
60
40
20
A-11
J-11
J-11
M-11
A-11
M-11
F-11
J-11
D-10
N-10
O-10
S-10
A-10
J-10
J-10
M-10
A-10
M-10
F-10
J-10
D-09
N-09
0
A Note on Performance:
150
DB-LCI Total Return
GSCI Total Return
140
USCI
130
120
110
100
90
A-10
S-10
O-10
N-10
D-10
J-11
F-11 M-11
A-11
M-11
J-11
J-11
A-11
Fixed Income:
Who would you rather lend
money to:
Bill Gates?
Or Donald Trump?
Fixed Income – Fundamental Weighting
RAFI Investment Grade Master
Merrill Investment Grade Master
RAFI Investment Grade 1-10
Merrill Investment Grade 1-10
RAFI High Yield Master
Merrill High Yield Master (BB-B rated)
RAFI High Yield 1-10
Merrill High Yield 1-10 (BB-B rated)
Total Return
7.07%
6.83%
7.03%
6.52%
10.03%
6.63%
8.92%
6.12%
Standard Deviation
5.88%
5.05%
4.92%
5.01%
10.82%
9.84%
9.37%
9.64%
Source: Shane D. Shepherd, “Fundamental Index Fixed-Income Performance: It’s All in
the Price,” The Journal of Index Investing, Spring 2011.
Conclusion
Indexing:
The Good, the Bad, and the Ugly