CHICAGO Holding stocks in a passive index fund as a core portfolio holding has generally been a rock-solid idea. You can own nearly the entire market at a low cost and not get snagged in market timing errors.
Yet most index funds are capitalization-weighted, meaning they hold the most popular stocks by market value. That could lead to owning the most overpriced stocks, which may incur more downside risk when the market heads south.
A better alternative could be to own "smart-beta" funds. While still built on indexes, the stocks within these baskets are often picked for their cash flow, book value, dividends and sales. That means instead of picking all of the potentially over-valued stocks that have won the market's latest beauty contest, more fundamental measures are applied.
Generally, smart-beta funds emphasize large stocks with healthy dividends that may not be everyone's favorite at the moment. Their portfolios may include a healthy dose of older, defensive and dividend-rich companies in manufacturing, utilities, healthcare and financial services.
The strategy behind smart-beta funds also leans toward fundamental indexing that relies on identifying the most-consistent companies year after year in terms of top-line sales growth and cash flow.
One such fund, the PowerShares FTSE RAFI US 1000 Index ETF, tracks an index of 1,000 stocks chosen for such fundamentals. It includes name brands like ExxonMobil Corp., Bank of America Corp. and General Electric Co.
These old-line firms are not exactly high-tech or IPO darlings that dominate the news, but they do have steady cash flow and dividends. Their prices might hold up better in a downturn.
The RAFI fund, which charges 0.39 percent for annual expenses, has one other distinction: In a year that has favored mega-caps, it has outperformed the S&P 500 Index. The fund is up more than 35 percent for the year through November 8, compared with 31 percent for the S&P Index.
While this has generally been a good year for big U.S. stocks, the longer-term outperformance of the RAFI fund is still robust. Its annualized return exceeds 20 percent over the past five years, compared with 16 percent for the S&P Index.
Although there's no guarantee that the fundamental approach or smart-beta advantage will hold up over longer periods of time, it's worthwhile noting that not all smart-beta funds do as well.
The PowerShares S&P 500 Low Volatility ETF employs a slightly different strategy than the RAFI fund. It's up 23 percent, compared with the S&P's 31 percent over the annual period through November 8. The fund charges 0.25 percent annually.
Keep in mind that smart-beta funds are more expensive than standard S&P index funds and may not always hold an edge.
For a basic cap-weighted index fund like the SPDR S&P 500 fund, for example, you'd pay 0.09 percent annually. That's less than a quarter of the cost of the RAFI fund.
The theory that a fundamental or low-volatility fund might shield you from stock-market risk may not be entirely valid, either.
The RAFI fund lost nearly 40 percent of its value in 2008, compared with 37 percent for the S&P 500. Its five-year standard deviation, a volatility measure, is nearly 20, compared with 16 for the S&P 500.
LOOKING DOWN THE ROAD
Will these returns continue? Although nothing fundamentally has changed in the economy of late - there's still a sluggish recovery in place - you'll still need to keep an eye on Federal Reserve policy.
If the Fed maintains its stimulus, it will continue to favor stocks, particularly large companies. Should it pull back the reins of its bond-buying program, stocks could retreat. Corporate earnings also need to stay on an upward course.
"If equities are going to sustain a move to the upside," writes Bob Doll, chief equity strategist for Nuveen Investments in his weekly newsletter, "we believe earnings must assume a leading role. More specifically, earnings and revenues need to advance, given that profit margins are pushing the bounds of sustainability."
As a way to buy and hold stocks, though, smart-beta funds may be a good vehicle for those who need long-term stock exposure. These portfolios represent some of the most durable companies in the world - and they pay steady dividends. While there is no perfect way to capture the upward momentum of growing dividends and profits, smart-beta funds may prove to be a reliable core holding.
(The author is a Reuters columnist. The opinions expressed are his own.)
(Follow us @ReutersMoney or here; Editing by Lauren Young and Dan Grebler)