Written by Heather Bell

The venerable Barron’s - owned and operated by Dow Jones (DJ), the same group behind the Dow Jones Industrial Average -launched a new index this week. Not that big of a deal, right? A few stocks handpicked by the editors to represent the broader market, maybe. Something that would live quietly within the pages of the weekly magazine, occasionally quoted by a Barron’s reporter, but largely ignored by the wider public? Not exactly.

The Barron’s 400, or B400, is more of a next-generation index than anything else: Its components are selected from the Dow Jones Wilshire 5000 based on the score assigned to them by the research firm MarketGrader (which has its own index family - see the article here). The MarketGrader methodology uses 24 different fundamental factors related to growth, value, profitability, and cash flow to determine a company’s grade on a scale from 0 to 100. The grade is designed to reflect the individual stock’s capacity for outperformance. Essentially, the new index represents the 400 stocks in the U.S. market that Marketgrader believes are most likely to outperform. Perhaps as a logical result, the components are equal weighted rather than market-cap weighted, which keeps the larger companies in the index from dominating and overshadowing the performance of smaller companies which may have better grades.

“When we were thinking about some kind of a Barron’s index, I think we wanted it to be somewhat in the spirit of what Barron’s does, which is essentially help people think intelligently about individual stocks and find opportunities in the market,” says Michael Santoli, an associate editor and columnist at Barron’s, who introduced the index in a September 3 article. He adds that Barron’s did not want to create another benchmark representing the overall market, but to create a “stock-picker’s index.”

Rather than simply including the stocks with the 400 best scores, the methodology that Barron’s uses to construct the index adds a few more parameters to the component selection process in order to ensure a diversified portfolio, according to Santoli.  Companies must have minimum float-adjusted market capitalizations of at least $250 million, and at least a quarter of the index’s components must have market caps above $3 billion. Component companies must also have a three-month average daily trading value of at least $2 million, and their most recent quarterly or annual reports must have been filed within the last six months.

REITs are excluded from the index, and although there are no minimum requirements for sectors, none can have more than 80 companies, or more than 20% of the index’s components (and weight). Because there are no minimum requirements, there are no companies from the Utilities sector and only one telecom company. The index currently has the most components in Industrials, Oil & Gas and Financials.

“Even though it will hunt in every sector to find components, it’s not going to capture a representative percentage of every sector. In that sense, it really is steering you toward where the fundamental momentum seems to be strongest and the stocks may not have caught up to that,” Santoli says.

The end result is a fairly unique index. The reliance on grades for component selection rather than market cap means that the largest company, Exxon Mobil, with a grade of 63.57 and a market cap of about $484 billion, shares equal space in the smallest stock in the index, Universal Stainless & Alloy Products Inc., which is currently worth about $218 million and has an impressive MarketGrader score of 77.09. Noble Corp. has the highest grade in the index, with a score of 87.86. The overall index has an average score of 65.08; in comparison the Dow Jones Industrial Average has a score of 62.29, while the S&P 500 has a score of 53.68. The Nasdaq 100, meanwhile, trails the other three indexes with a score of 42.36.

 

Index Returns

	1998	1999	2000	2001	2002	2003	2004	2005	2006
Barron’s 400	11.55	22.77	14.55	-1.77	-10.76	43.79	22.59	10.99	11.58
DJIA	16.10	25.22	-6.18	-7.10	-16.76	25.32	3.15	-0.61	16.29
DJW 5000	21.72	22.05	-11.85	-12.06	-22.08	29.44	10.67	4.57	13.75
S&P 500	26.67	19.53	-10.14	-13.04	-23.37	26.38	8.99	3.00	13.62

In terms of performance, the B400 is leading the DJIA, S&P 500 and DJW 5000 year to date, up 7.3%, and it has outperformed all three of the other indexes by significant margins in six out of the nine preceding years ... backtested granted. The only years it did not outperform each of the other three indexes were 1998, 1999, and 2006. It was at the bottom of the heap in 1998 and 2006, and second in terms of performance in 1999.

One notable drawback of the index is its high turnover. Although it is only rebalanced twice a year, it has an average turnover from 1998 of about 40%. That’s a change of 160 components every six months. However, the Barron’s article introducing the index points out that more than one-third of the components have been in the index for five years or more and two-Abercrombie & Fitch and Harley-Davidson-have been in the index for its entire history. Although the stocks’ scores are updated quarterly, Santoli says Barron’s decided the index would only be reconstituted semi-annually in order to minimize turnover. There were concerns that any further attempt to buffer the turnover would have a dilutive effect on the index’s purpose, he adds.

Another issue is that the article notes that MarketGrader is continuing to “tweak” its evaluation process, which raises the question of how significantly the methodology underlying the company’s stock ratings-and thereby the face of the index--could change. It also implies some questions about what dynamics in the market the designers of the index think that they are capturing.

But there is no doubt that the B400 is an interesting animal, even if it is hardly unique. The MarketGrader family of indexes draw the most obvious comparisons as they, of course, use the same methods to evaluate potential components. However, the indexes are much narrower, with the broadest index including just 200 components, while the B400 has twice as many. London-based SPA International has filed in the U.S. to create funds based on six MarketGrader indexes after doing so in the U.K. You can find the prospectus here.

Meanwhile, the Amex’s extensive series of Intellidex indexes also relies on fundamental analysis, which is provided by Revere Data, to highlight stocks with the greatest potential for capital appreciation. However, the universe of 2,000 stocks is much smaller than MarketGrader’s universe of more than 5,000 stocks. Components are evaluated on 25 different factors, a similar number to that in the MarketGrader methodology. The Intellidex indexes are also equal weighted. They have been licensed by PowerShares and underlie a large family of ETFs.

FTSE is also in the space. It has launched its own fundamental indexes, the FTSE RAFI indexes; the components in that series are based on just four fundamental factors rather than 24, and the weightings are based on a combination of component market caps and fundamental ratings.

S&P recently added to its STARS family of indexes. The new U.S. index includes all the companies in the S&P Composite 1500 rated 5 STARS (and sometimes 4 STARS) by S&P analysts. The index is also equal-weighted, and its weightings are reset on a monthly basis. Components are changed on an “as-needed” basis. A big difference is the number of components-the S&P index had around 70 at the time of its launch versus the B400’s 400 components. And most importantly, no matter how intensive the research, an analyst rating is still a subjective judgment rather than a purely quantitative assessment.

The index is scheduled for a rebalancing in the next couple of weeks, with the revamped index making its first appearance on September 24.The revised index will have a higher overall MarketGrader score, Santoli notes. While the index is trending upwards, the scores of its components usually trend downward. For example, although the index’s score at the moment is around 65, it was 71.5 after its previous rebalancing-after all, stocks chosen for their high scores are more likely to go down than up when there’s not much higher for them to go.

The B400 is calculated by Dow Jones Indexes, which is also in charge of licensing the index. According to a Dow Jones Indexes source, there have already been inquiries from potential licensees regarding the creation of investable products, including ETFs and an options contract, based on the index.