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Mutual funds have had something of a renaissance this year, in spite of a two-pronged assault from potentially high return, high cost hedge funds and usually low-priced index-tracking exchange traded funds. About $10,000bn of US wealth is held in mutual funds, a figure that dwarfs the $1,000bn-plus in hedge funds and less than $500bn in ETFs.

Yet a common complaint still holds: after expenses, only a minority of mutual fund managers consistently beat their chosen benchmarks. These are usually traditional market capital­isation-weighted indices such as the S&P 500 or the Russell 1000.

The power of compounded returns is easy to under­estimate and falling slightly short every year matters. Returning and reinvesting 10 per cent a year rather than the 9 per cent your neighbour makes will leave you with almost 50 per cent more wealth after 40 years.

So if fund managers fall short of reproducible index returns it hurts investors. But what if those index returns are themselves lower than can be achieved on index-like portfolios put together in a different but equally predictable way?

Indices based on fund­amental measures such as sales and dividends rather than market value aim to do just that. The argument goes that these objective measures are unaffected by investors’ mood swings and are better signals of future success than capitalisation which, by definition, gives too much weight to overvalued companies and too little to undervalued stocks.

The latest upstart to take on the giants of index investing with a product based on fundamentals is WisdomTree Investments, which listed a family of 20 ETFs on the New York Stock Exchange last week. Each tracks a dividend-weighted index. Back-testing suggests the new benchmarks have on average outperformed comparable capitalisation-weighted portfolios by at least 1-2 percentage points a year since 1964 – with lower volatility.

WisdomTree’s directors include Jeremy Siegel, professor of finance at the Wharton School of Business and author of Stocks for the Long Run and The Future for Investors.

“One thing that struck me in the late 1990s was how much dividends had gone down,” he says. “The more I investigated, I realised how those stocks that gave higher dividend yields gave better returns to investors.”

Siegel’s research suggests reinvestment of dividends accounted for 96 per cent of total stock market returns, after inflation, between 1926 and 2004. The WisdomTree LargeCap Dividend Index, for example, would have outperformed the S&P 500 by more than a percentage point each year since 1980, according to back-testing. The company’s SmallCap Dividend Index would have beaten the Russell 2000 by 5 percentage points a year.

The new ETFs aim to track those indices and a range of others in the US market.

Other WisdomTree funds offer new Japanese, Asian and broader international options for US investors as well as claiming benchmark-beating historical performance. The International SmallCap Dividend Index, for instance, would have returned nearly 16 per cent a year since 1996, against a reference capitalisation-weighted portfolio return of less than 10 per cent a year.

The new funds could serve as core holdings or as complements to existing port­folios, says Luciano Siracusano, WisdomTree’s director of research. He calls dividend-weighting the company’s “secret sauce” – an approach that has also attracted Michael Steinhardt, the prominent hedge fund manager turned philanthropist, who is the company’s chairman and largest shareholder.

Other ETFs track indices compiled using different fundamental measures. For example, this column has reported on a fund launched late last year by PowerShares tracking the FTSE RAFI US 1000 index – a portfolio of the 1,000 biggest US companies selected on a combination of sales, cash flow, book value and dividends. (FTSE indices are part of the group that publishes the Financial Times.)

PowerShares recently filed with the Securities and Exchange Commission to introduce 10 more ETFs tracking small and mid-cap US companies and a range of market sectors, with stocks again selected according to the RAFI criteria.

But some observers caution that raising investor awareness could eradicate the market inefficiencies that helped fundamental strategies outperform in the past. “What is to prevent hedge funds and other smart traders (not to mention the growth of fundamentally weighted index funds) from bidding up the price of those stocks with the highest weights in a fundamental index?” asks Tom Coyne, editor of indexinvestor.com.

“The very discovery of the fundamental and dividend-weighting anomalies should cause market capitalisation-based indices to become more efficient over time.”

In that light, it is fortunate that fundamental indexing is a David compared with the Goliath of traditional index tracking. About $240m is invested in the WisdomTree funds. More than $50bn tracks the S&P 500 through so-called Spiders, shares in the oldest and largest ETF on the market.

Copyright The Financial Times Limited 2019. All rights reserved.

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