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Alternatives to S&P 500 Index Funds

These standouts show there's more than one way to index the market.

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The 2005 Morningstar Investment Conference was last week (June 20-22), and among the most eagerly anticipated panels among Morningstar fund analysts was "The Right Way to Index" with PIMCO's Rob Arnott and Vanguard's Gus Sauter. Yes, yes, we fund analysts are aware that eagerly awaiting a discussion of index funds, much less the methodology of indexing, puts us smack-dab in the middle of Nerdville. Maybe that's ameliorated by the fact that what we most yearned for was a healthy debate over an idea that many investors might think an accepted fact: Market-cap weighted indexes are very solid foundations for passive investments.

The iconoclast on the panel, Rob Arnott, takes issue with that notion. A simplified version of his argument follows. While a firm's market cap is to some extent based on its fundamentals, it also reflects investors' forward-looking expectations for future growth, whether positive or negative. While some will achieve expectations, others won't, and their market caps will drop. Meanwhile, many firms will overcome low forecasts and grow larger than the market expects. And in a cap-weighted index, those firms that will eventually disappoint are automatically overweighted while those that will eventually be pleasant surprises are automatically underweighted. Arnott suggests that an index that uses fundamental factors is therefore superior, and he favors a combination of normalized sales, normalized cash flow, book values, and, when available, normalized dividends. Arnott also contends that, over the long haul, such an index will deliver superior returns (which he supports with historical information); he plans to put his management where his mouth is later this summer with the debut of PIMCO Fundamental IndexPLUS fund, which will use derivatives to invest in the largest 1,000 U.S. companies using his methodology.

Gus Sauter, long the indexing guru at Vanguard, disputes Arnott's claims. He characterizes such a methodology as having a distinct small-cap and value bias, one that will cause such an index to skew from the market's returns over time. In his view, whatever flaws a market-weighted index has, it's the truest and most liquid reflection of the market, enabling the largest number of investors to use it. Moreover, he suggests Arnott's returns-based data is time-period sensitive.

Todd Trubey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.