The Other Half of the Indexing Debate

Over the past few years, investors have been entertained by the mudslinging between two distinct camps of index investing: traditional indexers vs. fundamental indexers.

The first generation of exchange-traded funds (ETFs) mostly followed market-cap weighted indexes.

Then, in 2003, everything changed. PowerShares introduced funds that follow quantitatively driven indexes designed by the American Stock Exchange (Amex), known as “Intellidexes.” From then on, the number of ETFs following alternative weighting methods took off.

Traditionalists generally favor market-capitalization weighted indexes. By design, securities with the highest market-cap have a greater impact on the movement of the index. In this camp, is none other than Burton Malkiel, a professor at Princeton University, and John Bogle, founder of the Vanguard Group. Both experts have frequently made it a point to defend market-cap weighted indexes and to attack the back-tested results of fundamental indexes.

In the other corner are the fundamental indexers who claim to have identified a better way to construct indexes. By design, securities with the best fundamentals (high dividends, low valuation, etc.) receive a higher index weighting. Rob Arnott of Research Affiliates and Jeremy Siegel, a professor at The Wharton School of the University of Pennsylvania, have been advocates of fundamentally designed indexes. Each has taken their shots at highlighting the perceived flaws of market-weighted indexes.

Interestingly, a disproportionate amount of the debate has focused on just one aspect of index construction and management: how securities are being weighted. What about the other half of the debate?

Largely ignored in all of the mudslinging between indexing giants is how securities are being selected within indexes. Is it a passive, screened, or a quantitative approach? Listening to all the talking heads, one would be hard pressed to know anything but index weightings mattered.