New Complexity with New Indexes
Last week, Mike wrote a compelling post about index investing, specifically the complexities and volatility. I thought that was timely after reading the news that Russell Investments and a partner were creating 24 new indexes based on the Fundamental index methodology. This method uses adjusted sales, operating cash flow and dividends plus buybacks instead of market capitalization for weighting securities within an index. It’s a really interesting approach and seems to have numerous merits.
I’m not the right person to discuss the merits of one approach versus the other. This different approach brought a thought to mind: we should evaluate and scrutinize any backwards looking data closely. I have some first-hand experience with that.Our current work includes marketing a new fund-of-funds structure. Included in the marketing is a fund profile with a hypothetical investment. If we use the underling funds’ previous track records (2003-2010), we could imagine two scenarios:
- Equal Weighting, redistributed at the beginning of each year
- Max Performance, redistributing the money to the fund with the best return
Equal Weighting provides an investor with a 206% cumulative return. Max Performance returns 466% cumulative return. That’s a 250% difference. Obviously this is an extreme example and of course I would disclose my “Max Performance” method in a footnote along with “past performance does not predict future returns.” A prospective investor benefits from reviewing that disclaimer closely.
For many of the new index investments coming online, the investor (or advisor or research analyst) will need to perform a set of due diligence that he may have skipped when reviewing an investment with an S&P 500, Russell 1000, or other well-established indexes.