Growing up in a competitive bull market environment, we’ve all been conditioned to push the envelope and squeeze our portfolios to extract the maximum return possible.

Different styles work for different people. Some investors turn to actively managed mutual funds, employ market timing strategies or even resort to day trading while others followed the advice of John Bogle and Warren Buffett and utilize index funds.

Not all index funds are created equal. Index ETFs, once considered the plain vanilla option, have morphed into funds with sophisticated security selection and security weighting engines. Just like spring turns dormant bushes into colorful flowers, increased money flows have propelled index development in the ETF industry.

This article will not only address the nuances of varying investment approaches and index construction. It will also take a look at overriding market forces with the propensity to render ‘micromanaging’ worthless.

Index investing vs. stock picking

When John Bogle started the First Index Investment Trust on December 31st, 1975, competitors labeled him as “un-American.” Fidelity Chairman Edward Johnson “couldn’t believe that the great mass of investors are going to be satisfied with receiving just averaged returns.”

This was the birth of an ongoing rivalry between index investing and active management. By 1999, Bogle’s index fund, later on renamed the Vanguard 500 Index Fund (Nasdaq: VFINX), had gathered over $100 billion in assets and surpassed Fidelity’s hugely popular, actively managed Magellan Fund (Nasdaq: FMAGX) in the year 2000.

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Since the 1987 bear market ended, Bogle’s fund, initially dubbed “Bogle’s folly” by competitors, has matched the Magellan Fund’s performance. If you take into account the tax-advantages of the index approach, Bogle’s fund outperformed Magellan by a huge margin. In 2008, VFINX lost ‘only’ 37.02% compared to FMAGX’s 49.40% loss. So much for average performance Mr. Johnson.

A long term analysis of actively managed funds vs. index funds shows that between 60% and 80% of mutual fund managers underperform their benchmarks. Even a good mutual fund track record can be broken at any time.

Bill Miller’s Legg Mason Value Fund (Nasdaq: LMVTX), the only fund to outperform the S&P 500 for over a decade, dropped over 55% in 2008. The Weitz Value Fund (Nasdaq: WVALX), another (previously) highly regarded fund, shed 40.74% in 2008. As point of reference, the plain and boring S&P 500 ETF (NYSEArca: SPY) left investors with a loss of 36.68%.

More than three decades of actual performance numbers have shown that indexed investments tend to outperform actively managed strategies and stock picking.

More than just ‘plain vanilla’

Just as Buick owners may have to contend with the stigma of being conservative drivers, index based funds are often stamped as plain and boring. Unlike Buick though, which is on the verge of bankruptcy, index investing is more popular than ever before.

New index methodologies are trying to challenge the leadership position of market cap weighted indexes such as the S&P 500 (NYSEArca: SPY), Russell 1000 (NYSEArca: IWB) and Nasdaq 100 (Nasdaq: QQQQ). Market cap weighted indexes weigh their constituents according to size. The biggest companies have the biggest influence on the index’s performance.

WisdomTree has built an entire line-up of dividend weighted ETFs. This means that companies with the highest dividend yields dominate the index’s top holdings. Most dividend weighted ETFs have lagged in performance 
since the highest dividend yields originate from financial and real estate stocks which have suffered the most from the recent meltdown.

The WisdomTree Large Cap Dividend ETF (NYSEArca: ROI) has lost nearly 10% more than the large cap sector. The same holds true for the WisdomTree MidCap ETF (NYSEArca: DON) which is trailing behind the MidCap SPDRs (NYSEArca: MDY).

RevenueShares offers five revenue weighted ETFs. This common sense approach to security selection has improved long-term returns - according to back-tested models - but has not added significant value as of recent. The RevenueShares Small Cap Fund (NYSEArca: RWJ), for example underperformed the iShares S&P Small Cap 600 ETF (NYSEArca: IJR) over the past year before catching up as of late.

With two full lines of sector ETFs, PowerShares has set their sight at challenging the default options in sector funds, the Select Sector SPDRs. The PowerShares RAFI series weighs the individual components according to fundamental measures while the PowerShares Dynamic series uses a proprietary system to select index components.

The PowerShares Dynamic Financials Portfolio (NYSEArca: PFI) outperformed the Financial Select Sector SPDRs (NYSEArca: XLF) by as much as 25% while the PowerShares FTSE RAFI Portfolio (NYSEArca: PRFF) lagged behind.

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A deep emersion into the intricacies of index constructions may result in analysis paralysis. For those who want to dig deeper, a detailed analysis of all sector ETFs along with performance numbers and outperformance patterns is available in the March issue of the ETF Profit Strategy Newsletter.

The bigger picture

Most certainly there is value in identifying the best in class funds and ETFs. There is no reason why investors should settle for overpriced and/or underperforming funds.

The past 18 months however have shown that an understanding of the big picture, in terms of economic growth sustainability and stock market valuations, trumps any efforts to squeeze your portfolio for an extra percent or two.

Only a pro-active approach to the financial meltdown could have shielded your portfolio from the bear market’s wrath while asset allocation and diversification failed miserably.

To illustrate: An equal weighted mix of domestic equities, international equities, bonds, real estate and commodities would have resulted in a 48% top-to bottom (10-9-2007 – 3-9-2009) loss. This is better than the Dow Jones’ (NYSEArca: DIA) 52% drop but still unacceptable.

Investors willing to take a pro-active approach, hedging their portfolios with short ETFs or moving into cash, have fared much better.

The ETF Profit Strategy Newsletter has provided consistently accurate ETF profit strategies designed to profit in any market. It brand marked the financial sector as “a downward spiral with no stop-loss protection” already in September 2008 and recommended short ETFs, many of which gained 100% or more.

On December 15th, subscribers on record received the following piece of advice: “The best target for a low is 6,700 for the Dow and 700 for the S&P 500. Extreme pessimistic sentiment may drive the indexes even towards Dow 6,000 and S&P 600. Once the new lows are reached, the markets should stage the biggest rally seen since October 2007.”

The Dow bottomed at 6,446 and rallied over 20% since. While this rally will continue for a while, it won’t be able to fend off the bear for too long. Every investor should strive to identify the best in class ETF. However, even the best ETFs will lose money when the meltdown continues. You need to know when to hold’em and when to fold’em.

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