Technology Investor 

Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor.

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8:30 AM EST Monday, January 22, 2007: I really like index funds. My index funds have done better than many (not all) of my hedge funds. And, best yet, they have avoided the losses in my biotech-specific hedge funds. (Dumb. Don't ask why.) The local Vanguard index funds which I have and love are (in approx. order of performance)

+ Total International Stock Index.
+ Emerging Markets Stock Index Admiral shares.
+ International Value Fund.
+ 500 Index Fund Admiral shares.
+ Mid-Cap Index Fund Admiral shares.
+ Pacific Stock Index Admiral Shares.

An index fund typically mimics an index. This means the fund manager doesn't have to worry about picking stocks. He simply buys what's in the index, which is typically broad. Hence you get cheapness of management (the fees are low) and broad diversification. But there are many indexes. Which one?

Harry's solution: Don't buy one. Buy several. That's why I have six Vanguard funds in the U.S. and am getting one in Australia -- the one there that mimics their top 300 shares.

There are new wrinkles on index funds. To keep you informed (and confused), I've excerpted a piece from the weekend's New York Times. Be aware that Wall Street is a product -generation machine. Its job is to create new things for you and I as suckers to buy -- irrespective of whether these things make any sense or not. You can skim this piece. There's fun stuff below:

INDEX funds used to be simple. In fact, ever since indexing rose to prominence as an investment strategy in the late 1990s, simplicity has been a big selling point.

Traditional index funds remove much of the emotion and ego from investing. You buy and hold all the stocks that make up a market benchmark and achieve average returns, rather than trying to beat the market through active stock picking. There’s not much to it — and that’s been indexing’s strength.

But a group of market theorists have emerged recently with a take on indexing that complicates matters considerably. These so-called fundamental indexers say they can beat the market, not just match it, a core assertion that certainly seems to inject some ego back into the process.

Fundamental indexers say it’s not a matter of being smarter than the market, but of using common sense. They say it is possible to outperform traditional yardsticks like the Standard & Poor’s 500-stock index simply by reconstructing the benchmarks that the funds mimic — by reweighting an existing index or building a new one.

To followers of traditional indexing, the very notion of trying to beat the market by indexing the market is heresy — not to mention illogical. “It just doesn’t make sense,” said John C. Bogle, founder of the Vanguard Group, which started the first retail index fund, the Vanguard 500 Index, 30 years ago.

And to many investors, the distinctions between fundamental and traditional indexing may seem arcane. Both broad strategies call for buying and holding a diversified basket of stocks for the long run. And both try to keep costs down by avoiding active stock picking.

But traditional index funds tend to mimic indexes weighted by market capitalization, such as the S.& P. 500 or the Russell 1000 index of large stocks. In a cap-weighted index, stocks with greater market values have greater sway over the index’s performance. As the price of a stock rises, a traditional index fund reflects that rising value. Conversely, if a stock’s price drops, the value of the holding in a traditional cap-weighted fund will also fall.

What’s wrong with this approach? Well, what if the market isn’t always right — and misprices stocks from time to time?

Jeremy J. Siegel, a finance professor at the Wharton School of the University of Pennsylvania, said the bubble that formed in technology stocks in the late ’90s “really began to show how far stocks can be pushed away from their fundamental value.”

“We saw the biggest mispricing of equities in stock market history,” he said. Yet cap-weighted index funds put investors at risk by building their technology positions as the market became frothier and frothier. Then, when the Internet bubble burst, those investors saw those huge tech stakes get slammed.

That’s just the nature of the beast, said Robert D. Arnott, chairman of Research Affiliates, an investment management firm based in Pasadena, Calif., that is a major proponent of fundamental indexing. “With cap weighting, anything that is overvalued is overweighted by the index, and anything that’s undervalued is underweighted.”

Mr. Siegel and Mr. Arnott say they believe that there is a better way. They suggest that instead of building an index based on market capitalization, it is better to use fundamental factors such as earnings, dividends or cash flow to determine how much of a security the index fund should own.

In a momentum-driven market like that of the late 90s, such a strategy could lag, fundamental indexers say, because investors wouldn’t be riding the wave. Conversely, the strategy should hold up better in a falling market, because fundamental indexes were not as likely to be caught up in market hysteria.

“In a fundamentally weighted index, you don’t become a speculator,” said Bruce Bond, chief executive at PowerShares Capital Management, which recently opened several exchange-traded funds based on fundamental indexes created by Mr. Arnott’s firm, Research Affiliates. Over the last year, the number of exchange-traded index funds that adhere to this new approach has risen to around 50 from just 7, according to State Street Global Advisors.

But there is no denying that this new approach forces investors to make several layers of decisions.

For example, after deciding that indexing — and not active stock-picking — is the best way to go, you must decide which type of indexing to choose — fundamental or traditional. If the choice is fundamental indexing, you must decide which fundamental factors — earnings, sales, dividends or cash flow, for instance — are most important. Then comes another decision: Which recipe for a fundamentally weighted index is best, based on those variables?

There are already squabbles forming about whose theories of alternative indexing are superior. Wilmington Trust recently opened two retail mutual funds that tracked fundamentally weighted indexes. The indexes rely on three variables: dividends, free cash flow and net income.

By contrast, Mr. Siegel — who serves as senior investment strategy adviser to WisdomTree Investments, which has started 30 fundamental index funds — prefers to focus on dividends. Why dividends? They are “just about the only valuation metric where there is no dispute — where there’s no management manipulation,” he said. Mr. Siegel added that not only do dividend-paying stocks perform better than nonpayers over the long run, they also tend to fare better in bear markets.

BUT Mr. Siegel’s competitors point out that WisdomTree recently filed to register a new set of fundamentally oriented E.T.F.’s that weight stocks based on earnings. This would imply that WisdomTree doesn’t believe that dividends are the best way to weight an index in all circumstances. And Mr. Siegel agreed in a recent interview that “it’s wrong for me to say blanketly that it’s the best for everyone at all times.”

For his part, Mr. Arnott said he thought that a dividend-only model, while potentially effective in beating the S.& P. over the long term, could create portfolios that were not as broadly diversified as other funds. As an alternative, Research Affiliates has constructed several fundamentally weighted indexes using a combination of sales, cash flow, dividends and book value. Based on records from the last four decades, Mr. Arnott said, the Research Affiliates Fundamental Index 1000, a large-cap index, would have handily beaten the S.& P. 500. From 1962 to 2006, the RAFI 1000 would have generated an average annual return of 12.5 percent, versus 10.4 percent for the S.& P.

But Mr. Bogle said that “these are hypothetical returns for the underlying indexes that don’t take into account fees, costs and taxes” that would be associated with running an actual index fund. What’s more, he said, many fundamental index funds charge more in fees and have higher turnover rates than traditional index funds like the Vanguard 500.

Some critics say that the fundamentals approach isn’t really indexing at all. After all, they contend, a fundamental index provider has to select a method for weighting stocks that it thinks is superior to the collective wisdom of the market.

“What they’re doing is active management,” said Clifford S. Asness, managing principal at AQR Capital Management in Greenwich, Conn.

And because of the emphasis on fundamental factors rather than market capitalization, he said, it is a form of active management that tends to favor value-oriented stocks and smaller stocks. Mr. Arnott argues that fundamental indexing is a form of passive investing — that it simply ranks stocks based on their “economic footprint” rather than market capitalization.

Dodd F. Kittsley, director of E.T.F. research at State Street Global Advisors, said that while there were certain “active components” to this strategy, it remains a version of indexing. But he wonders how recent market trends may have affected the results of the approach.

“I don’t think it’s ironic,” he said, “that a lot of these fundamental index funds with a value and small tilt have come out at a time when value and small stocks have been doing extremely well.”

At the very least, it may be too early to tell how good these fundamental index funds are, especially because many lack even a one-year track record. “I’m holding off to see if these funds perform all that differently at the end of the day relative to traditional cap-weighted funds,” said Sonya Morris, editor of the Morningstar ETF Investor.

David R. Kotok, chairman and chief investment officer at Cumberland Advisors in Vineland, N.J., has begun investing some of his clients’ money in fundamentally weighted index funds.

But he has refrained from shifting his entire strategy to them, he said. “These are new vehicles. We just don’t know for certain how they’ll perform.”

More travel tips:
Don't bother locking your suitcase.
I watched a TSA lady blithely break open a lock on a piece of luggage. She was using the largest bolt cutters I've ever seen.
+ Some airline clubs now have showers. They make traveling almost civilized.
+ Most airports and airport lounges have Wi-Fi Internet access. Most charge like Starbucks. But some are free -- especially the international airlines, like Air New Zealand. For most traveling, you no longer need a dial-up account. Finally.
+ Jet lag is the worst. Today is a week after I came back from Australia. And I still have jet lag.

Apple announces the iPhone:You must watch this video. It's hysterical. Click here.

News from the telecom industry: You must watch this video. It's Comedy Central's Steve Colbert reporting on the new AT&T and the old telecom industry. What's most fascinating is that his take is actually true. Click here.

Seeing the light on buying bulbs: This is the MR16.

Decorators love it because it's small and concentrates light. In reality, it blows constantly and costs the earth. You can easily pay $10 at your local hardware store for one MR16 bulb. At (and other places on the net), you can pay as little as $1.49 for a non-branded but equally good bulb. The good news is they're now making MR16s in LED which should last longer -- but cost as much as $20 a bulb. I'm going to instal a few of the new LED MR16s and see what happens. For LED bulbs, click here.

Which browser for me? Microsoft's Internet Explorer or Mozilla's Firefox. Don't decide. Get both. They're both free. They both now have tabbed browsing -- meaning you open many sites simultaneously and you can flip between them. It's their best new feature in eons. For Mozilla Firefox 2, click here. For Internet Explorer 7, click here.

Note: some web sites only work with Internet Explorer. When using Firefox, these sites give weird error messages. Personally I prefer Firefox for most of my browsing.

Technology's side-benefit: Personally I love high definition TV, especially for nature wild life pieces. But it's not all rosy in the hi-def world. According to today's New York Times, "Pornographic movie studios have found that the high-definition format is accentuating physical imperfections in actors."

Jesse Jane plans cosmetic surgery to hide imperfections newly visible on Hi-Def, according to today's New York Times.

Why does this story amuse me?

I relate to this silly story:
A man feared his wife was not hearing as well as she used to, and he thought she might need a hearing aid. Not quite sure how to approach her, he called the family doctor to discuss the problem.

The doctor told him there is a simple informal test the husband could perform to give the doctor a better idea about her hearing loss.

"Here's what you do," said the doctor. "Stand about 40 feet away from her and in a normal conversational speaking tone see if she hears you. If not, go to 30 feet, then 20 feet, and so on until you get a response."

That evening, the wife was in the kitchen cooking dinner, and he was in the den. He said to himself, "I'm about 40 feet away. Let's see what happens. "

In a normal tone he asked, "Honey, what's for dinner?"

No response.

So the husband moved closer to the kitchen, about 30 feet from his wife, and repeated, "Honey, what's for dinner? "

Still no response.

Next he moved into the dining room where he was about 20 feet from his wife, and asked, "Honey, what's for dinner? "

Again, no response.

So, he walked up to the kitchen door, about 10 feet away. "Honey, what's for dinner? "

Again, there was no response.

So he walked right up behind her. "Honey, what's for dinner?"

"Earl, for the 5th time, "CHICKEN!"

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads. Thus I cannot endorse any, though some look mighty interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Claire's law school tuition. Read more about Google AdSense, click here and here.
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