"Intelligent" tracking -- road to riches or ruin?

An ETF, it tracks the 50 highest-yielding shares in the FTSE 350 index, with the constituents being weighted not by market capitalisation but one-year forecast dividend yield.

As with most other FTSE trackers, its constituents are recalculated every three months and its annual charge is just 0.4 percent -- comparing favourably to standard funds.

There are a handful of other funds, too, which work along similar lines.

New Star UK Strategic Income fund, for example, aims to deliver a high level of income, investing mainly in investment trust shares and other closed-ended vehicles, but can also invest in ETFs, unregulated collective investment schemes, money market instruments and deposits.

Meanwhile, Glasgow-based Fundamental Tracker Investment Management launched its first product, the Munro Fund, in September. An open-ended investment company, it invests in FTSE 350 companies, excluding investment trusts, weighted to total forecast dividend pay-outs.

Focusing on income in this way is a "natural progression" of investment techniques that home in on value rather than capital growth, says Rebecca O’Keeffe, head of fund management at fund supermarket Interactive Investor -- and an approach that is attracting a growing following.

"Equity income funds and EFTs are popular -- income is the most sold sector, particularly by the IFA (independent financial adviser) market, with a lot of people using these funds to generate retirement income -- and they’re going to remain popular," she says.

Against this backdrop, fundamental investing is set to grow.

"There’s no doubt that we are likely to see the growth of ’fundamental’ trackers in the future and this is something that I wholeheartedly welcome," says Andy Gadd, head of research at IFA Lighthouse Group.

Such funds eliminate common criticisms of traditional trackers, which hug the market and are not as low-risk as often perceived, as they over-weight overvalued stocks and are dominated by a few big multinational companies, such as BP.

"A capitalisation-weighted index over-weights companies that are trading above ’fair value’ and under-weights companies that are trading below true ’fair value’," says Gadd.

"These errors create a drag on the return of capitalisation-weighted indices and, therefore, on any index tracker following such an index."

American investor Robert D. Arnott found that if you weight a portfolio based on objective measures of company size that do not take account of share price or market cap, you add 2 percent to performance no matter which fundamental factor used.

But those who have put their faith in fundamental factors, such as dividends, have endured a bumpy ride of late.

The iShares FTSE UK Dividend Plus is down 18 percent in the year to date in capital terms, largely due to its predisposition to financial and consumer stocks, which have endured a torrid time, although a yield of 5 to 5.5 percent has offset losses. In contrast, the FTSE 100 is flat on the year, and has yielded around 3.5 percent.

"Financials have taken a real battering and high exposure to these and consumer stocks have meant that they (income-focused funds) have taken the brunt of adverse market moves this year," says O’Keeffe.

The picture could not have been more different in 2006, when iShares significantly outperformed Britain’s blue chip index.

It produced a capital return of 19 percent, while the FTSE rose just 10.7 percent.

The New Star fund is also down in the year to date, by 5.5 percent, but is up 186 percent over five years -- double that of its benchmark, the UK equity income sector.

Ed Bowsher, editor of personal finance Web site Fool.co.uk, believes such "value" funds could be strong long-term performers.

"History suggests that investors frequently pay too much for growth shares and don’t pay sufficient attention to the money-making potential of high-yield shares," he says.

Others are less positive. John Bogle and Burton Malkiel, grandfathers of the index tracking revolution, wrote in the Wall Street Journal last summer that the success of value investors is ephemeral.

Fundamental funds, the authors said, charge more than conventional trackers and churn their portfolios more.

And while value funds might do better than growth ones for a time, in the long run they produce the same return as the market -- and you will pay more than had you bought a conventional index tracker.

For passive investors, opting for a core of traditional trackers and adding fundamental funds as satellite investments could be one way to dip a toe into this relatively new market, says Lighthouse Group’s Gadd.

"It’s important for investors to fully understand how the index that is being tracked is calculated and any additional risks that this represents," he adds.

(Editing by Stephen Addison)