FTSE is launching new indices where shares aren't weighted by their market values. Instead the indices are based on fundamentals such as cash flow or assets.
At The Motley Fool we've been fans of tracker funds since our site was launched nine years ago. We've always liked their low charges and simplicity. If GlaxoSmithKline
(LSE: GSK)
, for example, comprises 7% of the FTSE 100 ("Footsie") by value, then a Footsie tracker fund will put 7% of its funds into Glaxo.
The only problem with this approach is that stock markets aren't always efficient. Sometimes, investors become gripped by a new fashion, or even a mania, and pay far too high a price for shares in popular companies.
Imagine the market became convinced, wrongly, that Glaxo's growth prospects were astonishingly good for a company of its size. As a result, Glaxo's price/earnings ratio rose to a jaw-dropping 40 and the share now comprised, say, 14% of the FTSE 100 by value. All through this rise, the tracker would be obliged to stay fully invested in Glaxo and, if necessary, buy more shares in the company to ensure that the tracker's weighting in Glaxo was the same as the Footsie's.
One way round this problem is to invest in a tracker fund that is based on fundamentals such as the iShares FTSE UK Dividend Plus. This fund tracks the 50 shares with the highest yield in the FTSE 350 index.
That iShares fund was arguably a pioneer in fundamental or "intelligent" tracking. The next step is sector-based fundamentals tracking and FTSE has launched 10 such indices tracking individual sectors in the US. Following on from that, Powershares has just launched funds tracking each of those indices. FTSE also plans to launch a fundamental index in the UK towards the end of the year and a tracker fund should be launched at the same time.
I see this as a positive move. I reckon these kinds of funds are effectively "value" trackers and I think they could be strong long-term performers. History suggests that investors frequently pay too much for growth shares and don't pay sufficient attention to the money making potential of high-yield shares.
Think of Altria
(NYSE: MO)
, formerly known as Philip Morris. It was the best performing share in the S&P 500 between 1957 and 2003, according to Jeremy Siegel in his impressive book, The Future For Investors. Tobacco wasn't a growth sector during that period, but the stock paid a chunky yield for much of that time, and patient investors received an excellent return.
The danger, however, with fundamental trackers is that you could miss out when markets are buoyant. If everybody is buying seemingly expensive shares in a sexy sector, you get some exposure to that momentum in a conventional tracker, but a fundamentals tracker may well be underweight in the fast-rising shares.
Perhaps conventional trackers are more predictable too. History suggests that popular indices such as the Footsie will probably rise over the long-term. Once you start investing in just a particular sector or by focusing on a particular investment metric, I think you increase the chance of something going wrong.
Find out more about index trackers and value investing.
