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ETFs with a Brain?

December 11, 2006 – by Richard Band

Index investing has come a long way. I can remember the skepticism and outright scoffing in 1976, when Vanguard introduced its Index 500 Fund, the first widely available mutual fund to mimic the Standard & Poor’s 500 stock index. “Who wants to be just average?” doubters taunted. Yet, over those three decades, the Vanguard fund has outperformed a sizable majority of actively managed funds.

Of course, the best actively managed funds (such as Dodge & Cox Stock Fund and Selected American Shares, two of my longtime favorites) have continued to beat the S&P by a handy margin. So the wizards of finance have gone to work, searching for ways to capture those extra profits while retaining the cost benefits of indexing.

The result: intelligent indexing, also known as “fundamental” indexing. This new breed of index funds doesn’t attempt to own the whole market or every company in a certain size range (small cap, mid-cap, etc.). Rather, intelligent index funds buy a basket of stocks that pass certain tests for investment merit.

Research has shown, for example, that stocks with above-average dividend yields have chalked up a higher total return than the market indexes over the past 30 years or more. By focusing on stocks with this fundamental characteristic, a new-wave index fund with a low cost structure may be able to perform as well, in the long run, as some of the leading actively managed funds.

The Old Guard Isn’t Amused

Intelligent indexing has met with a cool reception from most of the traditional mutual fund families. (Small wonder: It could put some portfolio managers out of a job.) Undaunted, proponents have launched a gaggle of exchange-traded funds that embody the concept, with the tempo of introductions accelerating in recent months.

I’m always cautious about new funds. Particularly in the case of exchange-traded funds, I prefer to see the shares build up a reasonable trading volume before I recommend them to you. We want to be sure we can sell easily, if necessary.

Thus, I suggest proceeding gradually with your purchases of intelligent ETFs. Start by accumulating funds that have proved themselves over the past couple of years, at least. One example:

iShares Russell 1000 Value Index Fund (NYSE:IWD). This is a core holding, suitable for almost any investor. The Russell 1000 index covers the 1,000 largest companies in the United States by market value. To whittle the index down to its value segment, the Frank Russell Co. uses a computer program to rank stocks according to their price-to-book- value ratio and their projected long-term earnings growth. The “cheapest” 50% of the Russell 1000 (by market capitalization) goes into the value index, while the rest of the stocks are placed in the growth index.

Has this system paid off? Handsomely. Over the past one, three and five years, IWD (at net asset value) has breezed past the average large-cap value fund tracked by Lipper. No doubt, the fund’s minuscule operating expenses — only 20 cents a year per $100 invested — has played a crucial part in those results.

Piling up Dividend Income

Another type of intelligent index fund that has come into its own lately is designed for income seekers. Back in the 1990s, many on Wall Street pooh-poohed dividends. After the Internet crash, however, the wisdom of the ages got the last laugh. Dividend-paying stocks are cool again.

So much so that a raft of ETFs have been created to focus on dividends. While I’m always glad to see the world beating a path to our door, it does concern me that some of the more recently minted dividend ETFs may not be following a well-thought-out strategy.

As a result, certain dividend funds have posted surprisingly mediocre results (so far, anyway). My top pick in the category continues to be the granddaddy of the dividend funds. It began trading in November 2003. From inception through June 30 of this year, the fund has notched an annualized total return of 12.6% at NAV, putting it about four percentage points a year ahead of the S&P 500.

The fund follows a simple, straightforward method of stock selection. The fund buys the 100 highest-yielding stocks in America (excluding REITs and master limited partnerships) that meet certain criteria laid down by Dow Jones, publisher of Barron’s and the Wall Street Journal, for size and financial strength. Banks and utilities form the largest industry groups in the fund’s portfolio. Unlike some other dividend ETFs, which concentrate as much as 10% of their portfolios in a single stock (dangerous), this one limits its largest holdings to about 2% each.

Current yield: 3.3%, after deducting the modest 0.4% annual charge for ongoing expenses. All of its quarterly payout qualifies for the low 15% maximum federal tax rate, and the fund has never issued a capital gains distribution.