Designer Funds: 4 Fundamental Favorites

12/13/2013 10:00 am EST

Focus: ETFs

Nellie Huang, of Kiplinger's Personal Finance, explores the world of designer funds, which use a fundamental approach to try and outperform traditional index funds.

Steve Halpern: Joining us today is Nellie Huang of Kiplinger's Personal Finance magazine. How are you doing, Nellie?

Nellie Huang: I'm great. Thanks.

Steve Halpern: In the latest issue of Kiplinger's, you've written an article on a trend in exchange traded funds, known as designer funds. Could you explain to our listeners what designer funds are and how they differ from more traditional ETFs.

Nellie Huang: Sure thing. Traditional indexes take a group of stocks, whether it's the S&P 500, or all of the stocks that trade in the US market, and they weight the stocks by market value. Meaning the bigger companies get the top ranking in the fund, and the smaller companies are kind of at the bottom, so fundamental indexes, kind of, turned that around.

They say, that's not good enough, because then larger companies are kind of driving the market, or the stocks that are doing well are driving the index up, and they take measures that are tied to a company's financial picture, so the healthiest companies get ranked at the top, the thinking goes.

Steve Halpern: Now, in your article you emphasized that there are potential downsides here. What risks and expenses should investors consider before buying these, so-called, designer funds?

Nellie Huang: I think the backdrop of this whole movement towards fundamental indexes is that people think that these indexes will outpace the traditional indexes, and some of the time, some of them do, and some of the time, some of them don't, and so, you have to accept the fact that you're investing in a pocket of the market, so it may not follow the market.

It's not always gong to outpace the market, but, over time, you may get a little bit more, “Oomph,” and when I say over time, I mean over the long haul, ten years, so that's one thing. Understand that your horizon has to be long if you want to beat the traditional indexes. Another downside is that some of them might be more volatile, so there might be more bumps in the road along the way, than with a traditional index. Also, they're slightly more expensive, so the annual expense ratio that you're paying every year might be a tad higher than with a traditional index ETF.

Steve Halpern: What criteria did you look at in your article in order to decide which of these funds you thought were worth recommending?

Nellie Huang: Well, there's so many, right, and they all have different strategies, some more complicated than others, and I kind of veered towards the more simple strategies, because they were easy to understand, and you want to understand what you're buying at the end of the day, and I wanted strategies that had over a five-year period.

We had to stick to that five-year period, because not many of them have existed for longer than that period. I wanted them to outpace a traditional index that was similar to the strategy that I was looking at in the fundamental index.

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Steve Halpern: Now, using these criteria, you highlighted a few fundamental index funds in your article that you consider as current favorites. Would you be kind enough to share some of those names with us?

Nellie Huang: Sure. I'll start with WisdomTree, three WisdomTree funds, since they, kind of, made the lion's share of the recommendation.

WisdomTree is a firm that has a philosophy that instead of ranking by the size of the market value of the stock, you should rank by the dividends they pay out or by earnings.

I looked at their funds—the dividend funds—specifically the WisdomTree International Smallcap Dividend, the ticker is (DLS), and the WisdomTree Emerging Market Smallcap Dividend, that ticker is (DGS).

Those funds had not only outpaced their traditional index, kind of brethren, but they were also less volatile, so you got bigger return, less volatility, and that's kind of the sweet spot of investing. It's a little bit of the Holy Grail, so I like those two funds a lot.

Another fund that impressed me was WisdomTree MidCap Earnings and that ticker is (EZM). WisdomTree takes annual earnings of each stock and ranks them by the annual earnings.

So, the companies that are more profitable will have more assets invested in them than the companies that are less profitable, and that fund also outpaced a traditional index ETF that was weighted by market value, by a considerable spread.

Steve Halpern: So, those three WisdomTree funds are all things that you think investors today could be considering?

Nellie Huang: Definitely! Definitely! The fourth one I mentioned in the magazine was RevenueShares Large Cap (RWL), and this is very simple.

It just takes the S&P 500 companies, the same exact companies, but instead of ranking by market value, as the S&P 500 does, it ranks by annual revenues, so those companies with more sales get higher billing in the fund than those with less, and that fund has done very well over the past five years.

Now, that fund came out right at the end of the, kind of, 2008 downswing, so it might have benefited from that, but still, the Fortune 500 is also a revenue generated list of companies, instead of by market value, and there have been many studies that have shown that revenue rankings can be very effective.

Steve Halpern: Thank you for joining us today. We appreciate your time.

Nellie Huang: Sure. Thanks for having me.

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