In a bold and somewhat
boisterous tone, the front cover of the September 3rd, 2007 edition of Barron’s
proudly announced a new stock index called the “B400” that “wallops the S&P 500
and the Dow.”
If you’ve been paying attention, even mildly so, you'll know that brash claims of market pulverizing performance is nothing new in the rapidly evolving exchange-traded fund (ETF) landscape. It’s what an entire generation of new ETFs are all about.
In the past, indexes were built to measure market performance. Today, indexes are being designed and contorted to beat the market.
PowerShares Capital Management was among the earliest ETF providers to introduce funds based upon “new and improved” indexing formulas.
Its two original ETFs, which were launched in 2003, the Dynamic Market Portfolio (Ticker: PWC) and the Dynamic OTC Portfolio (Ticker: PWO) are based upon the American Stock Exchange’s Intellidex system, which screen for stocks upon 25 selection criteria broken into four main groups: risk factors, timeliness (market momentum plus fundamentals), fundamental growth, and stock valuations.
In their short existence, these two funds have posted mixed results. Through the end of August, the three-year track record of the large cap blended PWC beat the S&P 500, whereas the mid cap oriented PWO slightly underperformed the S&P Midcap 400.
Interestingly, the B400 methodology sounds strikingly similar.
After starting with a broad market index (the Dow Jones Wilshire 5000) a company called MarketGrader filters companies based upon 24 different fundamental factors such as growth, profitability, earnings momentum and cash flow.
The 10-year hypothetical performance of the B400 is an impressive 12.37 percent, which “outperformed” the S&P 500, NASDAQ Composite and DJ Wilshire 5000 over the same time frame. But are these benchmarks really a fair analysis?
The DJ Wilshire has a weighted average market cap of $84.9 billion. In contrast, the B400 has almost 66 percent of its index in stocks with a mid cap, small cap, and micro cap market size. Wouldn’t a mid cap or small cap index, or even a blended benchmark, be a more accurate measure of how the B400 really stacks up? Of course it would.
Over approximately the same 10-year time period performance statistics reveal the S&P Smallcap 600 (+10.01%), S&P Midcap 400 (+11.80%) and the S&P Midcap/Citigroup Value (+12.69%) notched gains that rival the B400. Additionally, the S&P Midcap 400 and Smallcap 600 have had much lower annual portfolio turnover - averaging less than 15 percent in 2006 - versus a very elevated 80 percent average for the B400.
While the hypothetical performance of the B400 looks impressive, how it’ll fair in real life is uncertain. Ask any serious chemist and they’ll tell you laboratory results are far from conclusive evidence a new invention will work in real life.
Key unresolved questions remain: Will the margin of victory be great enough to justify the higher costs of the B400 and the new wave index ETFs like it? And will the margin of victory be a sustainable advantage throughout various market cycles, good and bad? It’ll take years of real life performance data before we have any definitive answers.
If history is any guide, and hypothetical histories don’t count, the odds of long-term market beating success are a long shot. Those who try to exploit the market’s imperfections, whatever they are, frequently end up becoming the exploited ones themselves.
Dow Jones Indexes plans to license its B400 index, which eventually will lead to an ETF and possibly even an index mutual fund.
Regarding the influx of new ETFs based upon these black box indexing formulas, John Bogle said: “It’s no accident that these new index funds are being introduced only after their strategies have seen their best days.”
Could the Barron’s B400 index have seen its best days?
If it has, B400 could become a B-52 index bomb failure.