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Index investing has created a challenge for active fund management. Indices outperform the majority of active funds over the longer term and many investors are waking up to this. According to a report from Standard & Poor’s, from 2002-07 the S&P 500 had beaten 72.2 per cent of all active large-cap funds surveyed.

This poor performance of active managers is driving both retail and institutional investors towards passive investing, particularly in the United States, where indexing is big business. If it is so difficult and costly to outperform the market, why try? Instead you should buy a fund that attempts to generate market returns and concentrate on getting your asset allocation right.

A recent report by Tabb Group Research estimates that active fund managers could lose as much as $12bn (£6.5bn) a year in potential management fees from the move to exchange-traded index funds. They are losing out to ETFs for a number of reasons, not least the fact they trade in real time on stock exchanges and can therefore offer diversification through a single trade. Their liquidity means they can provide greater investment flexibility than mutual funds, which tend to trade only once a day. ETFs are also transparent, with information on the underlying securities published daily. ETFs also avoid the pitfalls associated with other fund types – for example, unlike many unit trusts they are not likely to trade at a significant premium/discount, as ETFs are open ended.

Since they were first introduced in North America around 15 years ago, ETFs have come a long way. Morgan Stanley estimates that global ETF assets under management will exceed $2trn by 2011, and at the end of 2007, the global ETF market was worth close to $800bn, a rise of approximately 41 per cent on the previous year. Given the comparative advantages inherent in the ETF product and the widely documented outperformance of index investing over active management, it is no surprise ETF investment has been growing at such a rapid rate.

However, this basic “buy the index” approach does have the potential to be improved. While passive investing is markedly more successful than the average active manager, there are inherent inefficiencies in using a market-cap based approach.

By definition, market-cap weighted indices are the opposite of this simple investment formula. They have to add more stock as the price goes up and less as the price goes down, buying high and selling low in order to help keep the price-weight link intact.

Market capitalisation indices were not designed to be well-balanced stock portfolios. They are designed to measure the largest companies in the area they cover. They are not always well diversified – at the end of 2006, for example, the 10-largest stocks in the S&P 500 made up 20 per cent of the index. This could mean when you buy a traditional tracker fund with the intention of gaining exposure to a diversified selection of stocks in a particular market, you end up with overexposure to the largest stocks in the market.

A well-balanced portfolio should also be diversified by sector, but at any given time you can find that a market-cap based portfolio will be significantly overweight in certain sectors.

So what should investors looking to beat the index do? At present, alpha-seeking investors generally invest in fund structures like Oeics. Those looking for alpha have traditionally avoided index investing as, by definition, they want to beat the benchmark. However, researchers have worked to find new ways of constructing indices that enhance investors’ risk/return ratios, producing bespoke indices that beat the benchmark.

The idea is that you can improve the risk-adjusted returns offered by index funds by changing the type of index they track. Whereas traditional indices like the S&P500 rely on market capitalisation to select and weight stocks, fundamental indices rely on so-called “fundamental factors” such as price-to-book value or return on equity instead. The first fundamentally weighted ETF to hit the market was the iShares Dow Jones Select Dividend index, which focused on high-yielding US securities. Since then, a number of fundamentally weighted ETFs have launched, tracking indices that use a variety of metrics to choose and weight stocks.

Some fundamental indices will take an existing broadly based index and re-weight it according to one or more fundamental factors. This means an investor will have a holding in each of the stocks in the index, regardless of its fundamental attractiveness. These indices are designed to provide broad exposure to the market, essentially taking the place of an S&P 500 or Russell 1000 index fund in a portfolio, and the most famous example is probably the FTSE RAFI US 1000.

Others are more focused portfolios, offering more of a stock-picker’s index than broad market exposure. One of the benefits of a focused portfolio is the potential for higher returns, because in theory, the portfolio holds quality over quantity, but a focused portfolio will tend to have higher volatility and therefore potentially represents a higher-risk investment.

One example of “stock-pickers” indices are those created by MarketGrader, a stock research company based in Miami. These indices combine the principles of index investing and effective portfolio construction to create model portfolios of fundamentally attractive stocks. They work by analysing a wide universe of stocks, on the strength of their fundamentals to award each stock a rating relating to performance potential. The top-rated stocks are selected for inclusion in the index, subject to rules designed to ensure sensible portfolio diversification, such as the sector and size limits of the index.

These new products open up ETF investing to a broader universe of potential investors while retaining many of the benefits of a traditional ETF over an Oeic.

Market-cap based standard indices have already proved their popularity, particularly with institutional investors, but fundamental indices are likely to be even more popular in the long-term, as investors grow more and more disillusioned with the under-performance of active mutual funds and discover methods of generating more consistent performance with lower fees.

Daniel Freedman is managing director of SPA ETF