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NEW YORK, Aug 7 (Reuters) - As investors pour more and more money into funds that track indexes, the indexes themselves are getting more esoteric.
Challenging the very definition of "index," companies that construct these benchmarks are slicing and dicing the market in innovative ways.
Some strategies of late include funds which favor low-volatility or high-dividend securities instead of conventional products that track benchmarks like the S&P 500, which give greater weight to firms with bigger market values.
The latest in a series of products competing with traditional benchmarks is the Equal Risk Weighted Large Cap exchange-traded fund, launched by Connecticut-based VelocityShares launched last month. It re-balances the S&P 500 by assigning new weights to benchmark components to spread risk.
Welcome to the space between active and passive portfolios, also known as "active management in drag." These sometimes-funky benchmarks allow passive investors to make choices that can result in completely different bottom-line returns, leading to the view that these investments are not quite passive.
Passively managed funds are designed to mirror the performance of an index, with its component securities chosen in generally the same proportions as the index it tracks. Active fund managers use discretion in making trades in order to outperform a benchmark index. The risks of alternative indexes include the possibility of under-performance.
No one can classify what percentage of indexed portfolios exist in this realm. So far this year, $29.1 billion has moved into benchmarked ETFs that deviate from cap-weighting, a quarter of the $115.5 billion that flowing into ETFs overall in 2013, according to data collected from XTF, an analytics firm.
"It's creating a third way of investing between passive and active," said Brett Hammond, managing director at MSCI Inc , a major index provider behind some 500 exchange-traded funds.
While actively managed funds have long reigned in the larger, established mutual fund marketplace, which caters to retail investors, they account for less than 1 percent of assets in the faster-growing ETF space.
Two competing products tracking the strong-performing technology sector illustrate how the composition of an index can impact performance.
In one corner is the First Trust NASDAQ Technology Dividend Index Fund. It favors dividend-returning companies, like Cisco Systems Inc and Hewlett-Packard Co, and tracks a Nasdaq OMX Group index.
And in the opposite corner, the more popular iShares U.S. Technology ETF, with $2.3 billion in assets, tracks the Dow Jones U.S. Technology Index.
In the iShares ETF, Apple Inc represents nearly 17 percent of portfolio. In the First Trust ETF, Apple drives just 8 percent of the fund's return. That's because iShares fund gives greater weight to bigger companies.
So, as Apple stock lost 12 percent this year, the nearly $200 million First Trust ETF outperformed its cap-weighted technology counterpart. It's up nearly 18 percent compared to 10 percent for the iShares ETF through Aug 6, according to Lipper, a Thomson Reuters unit.
In all, index funds have seen almost $1 trillion in new cash between 2008 and 2012, a trend that is expected to continue.
Another example of the riff on conventional indexing is the nearly $440 million IndexIQ Hedge Multi-Strategy Tracker ETF . It attempts to replicate the reported performance of the hedge fund industry. To do that, an algorithm mimics an array of trading strategies including fixed-income arbitrage and market-neutrality.
All of that leg work is expensive, driving an annual expense ratio of 1.03 percent of the fund's value. The average ETF has an expense ratio of 62 basis points.
Rye Brook, NY-based IndexIQ has shouldered higher in-house research and compliance costs for the product than other firms because it built both the ETF and the benchmark it tracks, says CEO Adam Patti. He says the costs are worthwhile in part because the ETF is cheaper and more accessible than investing in hedge funds.
Critics like Ben Johnson, director of ETF research at Morningstar, said the IndexIQ fund's returns have been "paltry" compared to stock-market returns overall.
"I would say at a very high level the value hasn't been apparent," said Johnson.
Investors who do not understand the methodology underlying indexes - including its objectives, rebalancing schedules, weighting and holdings - risk their returns, said Rick Ferri, founder of Troy, Michigan-based Portfolio Solutions.
Duncan Rolph, managing director at Miracle Mile Advisors, which manages $220 million in ETF-only portfolios for high net worth clients in Los Angeles, said many of these funds are not suitable for his clients.
"When you dig into them and look at how they're inherently built they're really failing pretty miserably," he said.
According to Rolph, some benchmarks lead to portfolios without diversification, allocate assets poorly or fail to offer the market exposure they promise.
He pointed to the iShares Mortgage Real Estate Capped ETF . It follows a FTSE index intended to measure the U.S. real estate sector. The ETF invests about a fifth of its assets in Annaly Capital Management Inc, a real estate investment trust, creating a concentration risk he said is too high. The fund is down nearly 11 percent year to date.
FTSE, a division of the London Stock Exchange Group PLC , said the index tracks a "highly concentrated" market segment and meets regulatory diversification requirements. Custom indexes offer strategies that can mitigate this concentration risk, the firm says.
Kevin Kollar, managing director for FTSE Americas, said the company is increasing efforts to educate investors as it expands offerings across new markets.
"Is it a good thing? Is it a bad thing? It's neither - it's more of an evolution in the market," Kollar said. "Efficiency is always something the markets are looking to gain."