Passions run High on Indexing

It was quite a surprise for the debate over fundamental indexing vs. market-cap indexing to make it to the front page of the New York Times Business Section, but it has. In an article entitled, Passions run High on Indexing, by editor Joe Nocera, that appeared in the 17 May 2008 issue of the New York Times.

While few people can probably get excited about how indices weight their components, it matters to people in the ETF industry, because ETFs make money simply by having more assets under management. Any fund that has a secret formula for providing better returns may attract more investors.

The basic premise behind fundamental indexing, as proposed by Robert Arnott of Research Affiliates who has created the fundamental indices that underlie many Powershares products. His basic contention is that market cap weighting overweights the overweighted and underweights the underweighted, leading to underperformance in the long run.

His opponents claim that his system is not indexing. This is incorrect. It is simply an alternate form of weighting. Indexing is simply tying an investment to a particular index. The debate has gotten highly mathematical and arcane. Only time will tell who is right. However,
Arnott should not be counted out, as there is no doubt he is a very smart man -- he collaborates frequently with Peter Bernstein of Against the Gods: The Remarkable Story of Risk fame.

The other problem with many of his opponents' argument, is they see the S&P 500 as the “market.” This is not correct, as the S&P is not some unbiased measure of the “market” but 500 large cap stocks selected by the index committee at Standard & Poor’s according to criteria known only to themselves.

Leveraged ETFs -- Twice the Risk but not twice the return

A recent article in the Journal of Financial Planning. raises significant concerns about the use of leveraged ETFs -- those that multiply an index to increase the returns.

"Leveraged ETFs: A Risky Double That Doesn’t Multiply
by Two" by William J. Trainor, Ph.D., CFA and Edward A. Baryla, Jr. Ph.D.
Journal of Financial Planning, May 2008. pp 49-55.

This article investigates the performance of leveraged funds, those funds that are designed to multiply the return of a particular index. However, the ways the funds appear to work, means that the funds have some extra risks associated with them. The study comes to some important conclusions:

While leveraged ETFs can multiply index returns on a day-by-day basis, long run returns can not be multiplied by the same ratio because f a phenomenon known as the constant leverage trap and the lognormal nature of continuously compounded returns.

While many leveraged ETFs meet their specific daily targets, there is quite a bit of volatility related to meeting their targets on any particular day.

After using Monte Carlo simulations, the authors found that a typical 2X leveraged fund magnifies the index return only 1.4 times on an annual basis, for holding periods up to ten years. But the risk, as measured by standard deviations, stays double, or in some cases even quadruples in cases of extreme negative returns.

The authors compare leveraged ETFs to buying an index fund using a margin account and shows that the leveraged ETFS are superior in the long term due to their lower cost.

They caution long term investors to be wary of the risk/return tradeoff of leveraged ETFs, given that these types of funds can have extreme swings in value. However, they note that leveraged ETFs could be useful for short term investors/traders who are willing to take the risk and are taking a distinct position on the market.