Late in December, PowerShares launched the RAFI US 1000 Index as an exchange traded fund. Historians are likely to mark the occasion as the birthday of the third generation of index funds. The ETF (ticker: PRF) will embody the Fundamental Index of 1000 domestic stocks created by Research Associates' prime mover Robert Arnott.

What makes the Research Associates Fundamental Index US 1000 different from any of the nearly 800 index funds now available?

It is the first institutional-quality attempt to go beyond basic indexing.

Arnott built the RAFI index in proportion to fundamental measures such as sales, earnings, and book value rather than market capitalization. As noted in an earlier column on his research, the difference may add about 200 basis points a year (before expenses) over the return of the S&P 500 Index. That index, in turn, has beaten the majority of managed funds investing in the same arena.

While the marketing departments of managed funds are now crowing about how many large cap funds did better than the S&P 500 Index in 2005, the longer track record continues to show what it has shown for over 40 years.

Managed funds are undone by their trading costs, management expenses, and management decisions. While the S&P 500 index is regularly criticized as mindless, it remains that it bested the 10.89 percent average annual return of 5,386 large cap growth, blend, and value funds over the fifteen years ending November 30 with a return of 11.61 percent. It also beat the managed fund average over the last 10 years and 5 years and trailed in only the last 3 year and 12 month periods.

Mr. Arnott believes his Fundamental Index beats the market capitalization-based index because it avoids faddish overvaluations and fear-driven undervaluations. It does this, he believes, by concentrating on fundamental business realities rather than market valuations. Others say his index, with its extension to 1000 stocks and its predisposition to value stocks, may simply capture some of the additional return indicated by researchers Eugene Fama and Kenneth French.

Will the RAFI US 1000 beat the low expenses and tax efficiency of the Vanguard 500 Index fund and its clones?

Here's the math. You and I can buy an S&P 500 Index fund at expense levels as low as 9 basis points for an ETF (iShares S&P 500, ticker IVV). There are 100 basis points in 1 percentage point. The expense is very similar, 10 basis points, in index mutual funds from a major firm like Fidelity (Fidelity Spartan 500, ticker FSMKX, minimum initial investment $10,000). The PowerShares RAFI US 1000 Index ETF will have expenses of 60 basis points. That gives it a 50-basis-point disadvantage to the traditional index--- unless it can deliver the additional 200 basis points indicated by Mr. Arnott's back-testing research.

Will it?

I think it's a good gamble. If it works, the long term return would beat S&P 500 Index funds by about 150 basis points a year. If it doesn't, it should still be somewhat better than the average managed fund simply due to lower expenses.

Just as total market index funds are a better long term choice than an S&P 500 Index fund in Couch Potato portfolios, the RAFI US 1000 Index fund is likely to be a better choice than a total market index fund.

According to information from PowerShares, while 76.3 percent of the fund is large-cap stocks, the remaining 23.6 percent is spread across mid-cap and small-cap stocks. Similarly, while the Russell 1000 index has about 20 percent of its assets in information technology stocks because it is a market capitalization-weighted index, the RAFI US 1000 Index has less than half as much. It also has a smaller commitment to health care stocks than the market capitalization-weighted index.

Where does the Fundamental Index invest more?   Utilities, telecommunications, financials, and industrials. General Motors and Ford, for instance, still rank in the top ten investments for the Fundamental Index. Today, market cap based indexes treat them as if they were dead.   GM now has a lower market capitalization than motorcycle manufacturer Harley-Davidson.

Why should this be called a third generation index fund?

The first generation, which started in the '70s, duplicated a handful of very large, broad indexes. The second generation, which proliferated in the 90's, extended indexing to different countries and subdivided the domestic market into smaller slices. In both cases the idea was to have an index encompass and reflect every dollar of investment in a particular area.

The third generation introduces "rules"--- more complicated methods for selecting and proportioning portfolios. We're going to see a lot more of them. Some will work. Many won't. I think this one will.

On the web:

Index Funds: The Next Generation, Sunday, November 28, 2004

PowerShares FTSE RAFI US 1000 Portfolio

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