Stock-Net.com

Stock-Net reports on the continuing war of words between different stock indexing camps. John Bogle, a strong promoter of market-cap weighted indexing, in a recent article, takes aim at some of the newer index flavors just coming on the market.

In his article, Bogle attacks the foundations of the newer indexes, and their statistical analysis, as ‘data mining’, since the new indexes, by definition, do not yet have an extensive track record. He also criticizes the new indexes for their relatively high expense ratios.

The target of his attacks are some of the new indexes and ETF’s from Powershares and Wisdom Tree. For example, the Powershares RAFI 1000 ETF, symbol PRF, is based on a new index of ‘fundamental weighting’ instead of market-cap weighting. The idea behind fundamental weighting is to use Book Value, Cash Flow, Dividends, and Sales to weight a company in the index, and not simply its stock price. Their argument is that some stocks become overvalued or undervalued by the market, and a market-cap weighted index by design will over-invest in overvalued stocks, and under-invest in undervalued stocks, leading to a performance drag over time. A ‘fundamental-weighted’ index is designed to resist these tendencies and slightly overperform its market-cap weighted indexing competitor.

So far, this fundamental-weighted index has been performing well, with PRF beating the S&P500 index in 2006 by about 2 percentage points after expenses. Additionally, the PowerShares FTSE RAFI US 1000 ETF was awarded “Best ETF of 2006″ by SmartMoney.com, partially because of their innovative indexing approach.

A third contender in the indexing battle, Wisdom Tree, takes yet another approach. Their indexes include ‘earnings weighted indexes’ and ‘dividend weighted indexes’, which seek to steer away from cap-weighted indexes by utilizing more fundamental measures such as earnings and dividends to weight the index components. Two ETF’s from Wisdom Tree are the Wisdom Total Dividend Fund, DTD, and the Wisdom Total Earnings Fund, EXT. With expense ratios of 0.28%, the Wisdom Tree ETF’s provide a low-cost alternative indexing approach.

While the ultimate proof will come over time, so far the various indexes have shown themselves to be viable alternatives to the standard market-cap weighted indexes. You can see a performance comparison of these ETF’s in the graph below.

ETF’s are designed to track a defined benchmark or strategy, and typically rely on arbitrageurs to maintain a small tracking error between the ETF and the target benchmark. Stock-Net has an update regarding some ETF’s that have significantly strayed from their target benchmarks, spelling potential trouble for both investors and the affected ETF’s.

ETF’s are quickly growing in popularity among investors, because they can provide tax advantages, offer lower overall costs, and be traded continually during market hours. Many investors are taking it on faith that the ETF’s they invest in will track their intended benchmarks. But recently, some ETF’s have dramatically failed to effectively track their benchmarks.

For example, the US Oil Fund, USO, one of the fastest growing ETF’s last year has fallen more than 15 percentage points behind the oil price it was designed to track, leaving many investors scratching their heads.

Another set of oil funds, the Claymore MACROshares Oil Up fund, UCR, and the Claymore MACROShares Oil down fund, DCR, are designed to allow investors to profit from directional moves in the price of oil. However, recently the OilUp fund went down on a day when the price of oil went up. The Oil Up fund has been recently trading at an 8% premium to its asset value, while the Oil Down fund has been trading at a discount of 9% compared to its asset value. These factors make it very difficult to know what to expect if you choose to invest in these funds, and wise investors should closely follow the performance of these ETF’s both before and after investing.

Investors frequently choose to build or augment their portfolios with index funds. Once this decision is made, the next choice is deciding what vehicles should be used for index investing: Mutual Funds or ETF’s? Stock-Net brings you an overview of the state of the indexing investment world to assist in this choice.

In the world of index mutual funds, Vanguard reigns supreme, offering a wide range of low-cost funds. Vanguard index funds typically have a $3,000 minimum investment and offer some of the lowest expense ratios in the industry. Fidelity offers some index funds, but offers mostly actively managed funds. For the more adventurous, Rydex offers a family of index funds, some of which are leveraged and inverse-tracking index funds. Rydex funds generally have higher expense ratios, but are made for active trading, if that is your focus.

ETF’s now have captured the center of gravity of indexing funds. ETF’s now include indexes for a very wide variety of asset classes, with asset classes being sliced and diced in almost every imaginable way. ETF’s can also offer very low expense ratios, and some tax advantages over mutual funds. Some of the newer ETF’s, however, come with some fairly high expense ratios, so do your homework before investing.

There are so many index choices available in ETF’s, it pays to do some research to sort through the offerings and locate what you are really after. Fortunately, there are several good sources of information about ETF’s. One good source of ETF information is the Morningstar site, where you can enter ETF ticker symbols and view their corresponding Morningstar reports. You can also find a variety of ETF information at Yahoo finance ETF section.

MSN Moneycentral has ETF information, including articles of general interest. You can find a categorical breakdown of ETF’s at SeekingAlpha.com, as well as current articles related to ETF’s and investing in general. Finally, you can go straight to the source of the largest provider of ETF’s, Barclays. Their website at ishares.com contains some nice searching features to allow you to quickly locate ETF’s based on their categories. Even though the possibilities for index investing are almost endless, these research sites allow you to sort through your options and find the right funds for your portfolio.

Growing assets of ETF’s are apparently beginning to roil some small stocks, at least according to recent research. Stock-Net has looked into this, and wonders if this is a mere curiousity or a true trading opportunity?

The news comes from Prudential Equity Group research, who studied the effects of trading small-cap ETF’s upon the underlying small cap stocks tracked as part of the ETF’s indexing. As dollar-volumes increase in the ETF’s, trading volumes of the underlying small cap stocks in the index increase. For some small cap stocks, the ETF-driven volumes can become a significant part of their average daily trading volume. According to the research, ETF-driven volume can produce more than 30% of daily volume of some small-cap stocks.

In the research, the iShares Russell 2000 ETF was studied for its impact on some underlying small cap stocks. With $11 Billion in assets, the Russell 2000 ETF can produce some significant trading volumes for its tracked securities. Here are some of the securities highlighted as having a significant portion of daily trading volume driven by ETF’s:

• Shore Bancshares, 53%
• SCBT Financial, 52%
• Shenandoah Telecom, 44%
• Univest Corp of Pennsylvania, 42%
• Smithtown Bancorp, 38%
• First South Bancorp, 37%

Keep this factor in mind the next time you see unexplained volume on your favorite small cap stock, it could be driven by ETF trading activity.

Updating my earlier post about  Dividend ETF’s, here are additional high-yielding ETF’s.

• IShares Lehman TIPS Bond, symbol TIP, currently yields 5.89%
• IShares Investop, symbol LQD, currently yields 5.06%
• IShares Lehman 20yr Bond, symbol TLT, currently yields 4.58%
• DJ Wilshire REIT, symbol RWR, yields 4.54%
• Vanguard REIT ETF, symbol VGD, yields 3.82%
• Rydex CurrencyShares Mexican Peso, symbol FXM, yields 3.65%

Any of these should be a good addition to a US-stock centered portfolio, providing additional diversification and a good boost of dividend yield.