For those not following the fundamental indexing phenomenon, here’s a brief primer.
Influenced by the 1999 technology stock bubble and its disastrous consequences for investors, Robert D. Arnott, chairman of Research Affiliates, came up with the idea of fundamental indexes. Instead of weighting stocks in an index by their capitalization — the tried and true way acknowledged by people like Vanguard’s Jack Bogle as the only way to index — this new indexing strategy weights them according to fundamental factors, such as revenues, or earnings, or a combination of such factors.
Why was the tech bubble an influence? As the thinking goes, when there’s a bubble, there are unrealistically high stock prices. When those stocks are a major component of an index, the index then disproportionately represents the value of some of its components. The index still measures the true market value of its stocks, but some of the stocks’ prices don’t measure the true value of their companies. “Fundamentalists” would say: If the price is wrong, then the weighting in an index is wrong.
Fundamental indexing is the way to get around these ever-changing misevaluations. If stock values aren’t reliable, revenues and other fundamental measures of a company’s presence in the economy are significantly more stable and representative. Some critics say this shift in valuation will overemphasize value versus growth stocks. Yet, academic research already treats as common wisdom the fact that value stocks outperform growth stocks a majority of the time.
So the debate rages on: Is fundamental indexing real indexing, or is it just another formulaic attempt to beat the market? Let’s see what your peers think. (Here’s a hint: More dislike it than not).
Reasons to Dislike ItFundamental indexing is new, unproven and, therefore, uncertain. Dylan Ross with Swan Financial Planning in East Windsor, N.J., puts it this way: “From a financial planning standpoint, there is already a degree of uncertainty in the markets. Investing in fundamental index-tracking investments adds additional uncertainty. If a goal of financial planning is to minimize uncertainty, cap-weighted indexing may be the better option for the individual investor.”
High fees wipe out return advantage. Steve Condon of Truepoint Capital in Cincinnati notes: “The management fees charged by fundamental index products are often much higher than those of comparable index or passive funds.” Adds Aaron Skloff of Skloff Financial Group in Berkeley Heights, N.J.: “Fundamentally weighted index funds are likely to produce after trading, management, marketing and other costs, returns similar to their respective market-capitalization- and valuation-based indices over multiple market cycles.”
Bobbie Munroe of Fraser Financial in Atlanta provides some numbers to back up these claims. “Take the FTSE RAFI 1000/PRF [a fundamentally weighted ETF]. As of July 15, 2008, the top eight out of 1,000 holdings comprised over 18 percent of the fund. And the expenses run 0.6 percent versus 0.15 percent for a cap-weighted ETF. [With this expense structure], PRF has to perform significantly better than its cap-weighted counterpart just to break even.”
It’s nothing more than value- and small-cap stock investing. Says Pam Poldiak of Fee-Only Financial Planning in Roanoke, Va.: “As just a new way to market an old idea — that value and small-cap stocks perform better than growth and large-cap stocks — fundamentally weighted indexes are just a marketing gimmick. [Theorists Eugene Fama and Kenneth French] came up with this theory a long time ago, and Dimensional Fund Advisors [DFA] has been offering funds targeting small-cap and value stocks for over 25 years. Any investor can create an index portfolio targeting small and value stocks by simply buying ETFs from iShares or Vanguard — all at a much lower cost than the fundamentally weighted funds.”
Higher risk, higher return. “Arnott is going around the country saying that fundamental indexing is better because it outperforms the S&P 500,” says Sean Sebold of Sebold Capital Management in Naperville, Ill. “Gee whiz, do you think small-caps will outperform large-caps over a long period of time? Of course, but the risk profile is different. This is something that is neglected in the marketing materials.”
You get the same thing with equal-weight indexes. Maurizio Piglia, a director at S&I Savings and Investments of Auckland, New Zealand, says: “To beat a cap-weighted index, you just have to equal-weight its components and the bias you obtain versus smaller-cap stocks is enough to pay you a higher return — in exchange for higher risk.”