There are bad index funds. Are there better ones?

ByABC News
December 8, 2011, 6:10 PM

— -- Good ideas can always be made worse. Cellphone? Good idea. The guy next to you talking about his warts? Bad idea.

Index funds? Good idea. Index funds that follow bizarre indexes? Bad idea.

Despite the slew of new, bad index funds, however, a few recent twists on indexing make some sense.

Index funds simply track an index, such as the Standard & Poor's 500-stock index. Indexing has many virtues:

•Low cost. Index funds don't use a manager, so they can slash expenses. The Vanguard S&P 500 Index fund, for example, charges 0.18% in expenses, or $18 a year to manage a $10,000 investment. Over time, low costs give index funds a huge edge on more expensive funds.

•Low taxes. Your fund will probably make a capital gains distribution this month. The distribution is taxable, which is why it's best to avoid buying a fund late in the year: You'll buy a year's worth of the fund's tax liability without enjoying a year's worth of its gains.

Index funds, however, are inherently tax-efficient, and most pay little or nothing in capital gains distributions. (They do pay dividend distributions, which are taxable).

•No manager. Index funds don't have performance lapses because they're getting divorced or huffing glue. While index funds won't protect you in a downturn, few managers do that, either.

The ETN promises double the monthly returns — up and down — of the ISE Cloud Computing Total Return index. What's that? The UBS website says it: "uses a market capitalization weighted allocation across pure play, non-pure play and technology conglomerate categories, as well as an equal weighted allocation methodology for all constituents within each such category."

Got that? So you have a fund formed around an investment buzzword — cloud computing! — that follows an obscure index. Oh, and the index's history began in June. Bad idea. Dozens of similarly bad funds have rolled out this year.

Still, some newer variants of index funds may (or may not) have some merit.

•Equal-weighted indexes. The S&P 500 is weighted by the market capitalization of a company's stock. Market cap is the number of shares outstanding, multiplied by current share price. In a cap-weighted index, the largest stocks get heaviest weights. The 10 largest stocks in the S&P 500 make up 19.6% of the index.

The drawback is that cap-weighted indexes can be larded with the stocks of expensive companies, such as technology stocks in the 1990s.

An equal-weighted index has the same number of shares for each company. The advantage: It fares better than a cap-weighted stock index does when small companies do well. The disadvantage: It fares poorly in a large-cap rally.

•Dividend-weighted indexes. A company that pays out a great deal in dividends tends to be financially strong. The drawback: Until the financial crisis, many big dividend payers were also big banks. Back in 2006, for example, Bank of America was 4.9% of the WisdomTree large-company dividend-weighted index. The bank had a 2% weighting in the S&P 500.