Investors Bombarded by Index-Fund Choices

But Many of Latest Offerings Stretch Definition of ‘Index’; Warnings of Increased Risks

Index-fund investors, known to take a hands-off approach to their money, are now being asked to make some big decisions — and possibly take on more risk.

Index funds traditionally have aimed to mirror the performance of broad-market benchmarks, such as the Standard & Poor’s 500-stock index or the Dow Jones Wilshire 5000 Composite index. This made the funds relatively predictable, since investors could expect to closely track the market’s return, minus a small slice for management expenses. Another attraction: Index funds have historically outperformed the majority of funds that rely on a fund manager’s active stock picking.

Now, however, investors are embracing a slew of new specialized funds that have exploded the idea of what an index fund is meant to track. Fund companies, aiming to differentiate their offerings and levy higher fees, are slicing and dicing the market in various new ways. Many of these “alternative” index funds are less than a year old and have yet to establish a meaningful track record.

Some firms are even inventing new indexes to track. WisdomTree Investments Inc. offers dozens of exchange-traded funds — essentially, mutual funds that trade like stocks — that track indexes composed of dividend-paying stocks. (Generally, the bigger the dividend, the more weighting the stock has in the index.) VTL Associates LLC is planning to launch three ETFs that track indexes weighted by the size of company revenues. That’s a big departure from traditional indexing, which weights stocks based on their so-called market capitalization, or total stock-market value.

Other funds target indexes focused on narrow market niches, including the newly launched PowerShares Buyback Achievers Portfolio, an exchange-traded fund that invests in companies buying back their own shares, and the Claymore/Ocean Tomo Patent ETF, which buys stocks of companies based on the value of their patents.

Yet many financial advisers and industry experts fear that the alternative index funds sacrifice many of the traditional benefits of indexing, including low cost, broad diversification and simplicity. Experts also see risks to investors in many of the new funds that track narrow, volatile market segments, such as commodities and currencies. Some funds employ complex financial products such as derivatives, or use borrowed money, which can juice returns on the upside but also amplify downturns.

Fees are also an issue. Many offerings from WisdomTree and PowerShares Capital Management, another major seller of alternative index funds, charge expenses of roughly 0.5% to 0.6% of assets. While that makes them cheaper than many actively managed mutual funds, they are more expensive than some traditional index funds, such as those offered by Vanguard Group and Fidelity Investments, which charge as little as 0.1% to 0.2%.

“Investors should not just buy into [alternative index funds] thinking they’re getting the passive replication and low costs and longer-term outperformance of indexes,” says Srikant Dash, an index strategist at Standard & Poor’s, who has developed both market-cap-weighted indexes and newer alternative indexes.

As the world of index investing grows more complex, financial-services firms are rolling out new types of accounts, with minimum investments of $25,000 or more, to help high-end investors make sense of it all. For an added fee, typically 1% of assets or more, firms including A.G. Edwards Inc. and Citigroup Inc.’s Smith Barney brokerage unit will help you build a diversified portfolio using only index-tracking investments.

Interest in indexing has soared in recent years, thanks in large part to its popularity in retirement plans and among hedge funds. Assets in index mutual funds and exchange-traded funds accounted for 14% of the roughly $7.3 trillion in long-term mutual-fund and ETF assets as of November, up from 9% at the end of 2000, according to Financial Research Corp.

New and narrowly focused index funds are drawing much of the new money. Among the 10 ETFs taking in the most money in 2006 are iShares FTSE/Xinhua China 25 Index and iShares MSCI Brazil Index, according to fund-tracker AMG Data Services.

Many alternative index funds aim to solve what their proponents say is a basic problem with market-cap weighting. As a stock’s price climbs, market-cap-weighted funds must buy more shares, forcing them to overweight overvalued stocks and underweight underpriced shares, critics say. Providers of alternatively weighted indexes say they can shelter investors from market bubbles and their ugly aftermath, and get better returns. Index strategies “don’t have to be market clones,” says Robert Arnott, chairman of Research Affiliates LLC, which offers indexes based on a variety of company fundamentals, including revenues and dividends.

One alternative is to weight all the stocks in an index equally. Morgan Stanley, for instance, offers an S&P 500 fund that gives each stock equal representation instead of weighting holdings based on market capitalization. Over the past five years, class A shares of the Morgan Stanley Equally-Weighted S&P 500 fund, which charge 0.63% in fees, delivered annualized returns of 10.9%, beating the traditional market-cap-weighted S&P by more than four percentage points. Rydex Investments recently launched nine equal-weighted ETFs focused on various market sectors. Other equally-weighted ETFs include KBW Regional Banking and First Trust Portfolios LP’s Nasdaq-100 Equal Weighted Index.

But investors need to understand the bets they’re taking with such funds, advisers say. “With equal weight, you’re really just dialing up the small-cap factor,” says David Yeske, a financial planner in San Francisco. While small-cap stocks have outperformed large companies in recent years, there’s no guarantee they’ll do so in the future.

What’s more, equal-weighted funds may come with higher expenses and less tax efficiency than traditional index funds. As stocks’ prices change, their weighting in cap-weighted indexes generally remains the same, so little trading is required. But equal-weighted indexes must trade more as stock prices move, which drives up transaction costs. More trading also increases the potential for a fund to run up capital gains, which can saddle investors with a tax bill.

Advocates of alternative indexing often can’t agree on the best way to index. WisdomTree’s new LargeCap Dividend ETF, for example, tracks the firm’s own WisdomTree LargeCap Dividend Index, made up of the 300 largest dividend-paying U.S. companies by market cap. Each company’s weight in the index is based on the size of its dividend, with the biggest weightings going to Citigroup, General Electric Co. and Bank of America Corp.

While companies can manipulate earnings and other fundamental measures, “there’s no debate about how much the dividend is,” says Jeremy Siegel, a finance professor at the University of Pennsylvania’s Wharton School and WisdomTree’s senior investment strategy adviser.

The problem, counters Research Affiliates’ Mr. Arnott, is that most U.S. companies don’t pay dividends, and those that do are concentrated in a few sectors like financials and utilities. A dividend-weighted U.S. stock index isn’t truly a broad market index, he says.

Meanwhile, brokerage firms are launching accounts to help customers navigate the more-complex world of index funds. TD Ameritrade Holding Corp. late last year launched Guided Amerivest, an account that helps clients with a minimum $50,000 build ETF portfolios for an asset-based fee of 0.65% to 0.8%, not including expenses of the underlying holdings. A.G. Edwards has several new types of fee-based, or “wrap,” accounts constructed entirely of ETFs.

For individuals investing $25,000, A.G. Edwards charges 1.5% to 2.25% of assets annually for an ETF wrap account. Smith Barney offers an ETF wrap account, for a minimum of $25,000, that charges expenses of 1% to 1.5%. The accounts help investors choose index funds, allocate money among them and periodically rebalance holdings.

Some firms will help wealthier investors construct a customized index, using individual stocks and rejiggering some of the holdings. Northern Trust Corp. and Wilmington Trust Corp. have both launched such accounts using fundamentally-weighted indexes in recent months.

But some of these accounts might only approximate an index’s result, because they aim to replicate an index by buying just a few of its constituents. In a $100,000 account tracking the S&P 500, for example, index-based managed account specialist Active Investment Advisors will typically hold just 50 stocks, say Curt Overway, the firm’s president. The returns of such an account may deviate from the index’s returns by as much as 4 or 5 percentage points annually, though the performance difference is very small over a 20-year period, Mr. Overway says.

“You take a horrible risk of underperforming” when you hold a small sample of the full index, says William Bernstein, author of “The Four Pillars of Investing.” Such an account is likely to eliminate some of the top-performing stocks in the S&P, causing it to substantially lag the index over time, Mr. Bernstein says.