-- 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.
How does a good idea go bad? By trotting out trendy funds that follow newly minted indices. Consider the UBS E-TRACS Monthly 2x Cloud Computing Exchange-Traded Note, which trades under the ticker lsky.
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.
•Earnings-weighted indexes. These give the biggest weight to the companies with the most earnings. ExxonMobil is the largest holding in the WisdomTree Earnings 500 index, accounting for 4.4% of the index. ExxonMobil is the second-largest in the S&P 500 — behind Apple — and is weighted at 3.4% of the S&P 500
Fran Kinniry, principal of Vanguard's Investment Strategy Group, doesn't think much of alternate indexing strategies. True, they have periods when they fare well, he says, but market capitalization reflects the market as it is. "No one will argue that market capitalization doesn't represent the aggregate and collective dollars of all investors," he says. Using different strategies, he argues, simply reflects a decision to overweight or underweight certain kinds of stocks.
Vanguard, of course, is a leading provider of market-cap-weighted index funds, and the vast majority of index funds are cap-weighted.
Would it be a bad idea to mix a few broad-based variants in your index portfolio? Probably not. Would it be a bad idea to invest in a new, narrowly focused index fund? Why, yes, it would.
John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. See an index of Waggoner's columns. His book, Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. John's e-mail is email@example.com. On Twitter: www.twitter.com/johnwaggoner.