"Fundamental Weighting" and Indexing
Joseph Nocera reviews the bidding:
Passions Run High on Indexing: the Financial Analysts Journal... letters the magazine published in its March/April issue. André Perold, a finance professor at Harvard Business School, had written an article in a previous issue criticizing a new kind of financial product called fundamentally weighted indexes, which have been devised in large part by a man named Robert D. Arnott. Mr. Arnott is the chairman of Research Affiliates, a six-year-old company that markets and licenses such funds — and he’s also the former editor of The Financial Analysts Journal. “André Perold’s article in the November/December 2007 issue entitled ‘Fundamentally Flawed Indexing’ might have been better titled, ‘A Fundamentally Flawed Critique,’ ” steamed Mr. Arnott, in a letter jointly written with the Nobel laureate, Harry Markowitz, who is one of his consultants.
Mr. Perold quickly shot back (“This characterization is completely inaccurate.”), as did several other participants in the debate. It reminded me of the good old days at The New York Review of Books, when authors would spend issues on end cagily insulting each other in the letters page. There is nothing quite like an old-fashioned academic cat fight....
At its core, the fight is about whether fundamentally weighted indexes — which, unlike traditional index funds, don’t rely on market capitalization to “weight” a stock in an index — are superior to old-fashioned index funds, which allow investors to invest in such broad market indexes as the Standard & Poor’s 500 or the Russell 2000.
Obviously, Mr. Arnott thinks the answer is a resounding yes; so convinced is he that he is onto something big that he’s trying to patent his methodology. Mr. Schwab, Mr. Markowitz and Jeremy Siegel, the Wharton economist who serves as a consultant and spokesman for Mr. Arnott’s chief competitor, Wisdom Tree Investments, are all in this camp.... Critics include Mr. Bogle — who helped create the original index fund — Mr. Malkiel, Mr. Perold (who is a Vanguard director), and Clifford Asness, the co-founder of AQR, a big quantitative hedge fund.... I came away thinking they’ve both got a point....
A traditional index fund is a mirror of the market. The Vanguard 500 Index Fund, for instance, replicates the stocks in the Standard & Poor’s 500... larger market capitalizations have a larger weighting in the index than stocks with smaller market caps. Investors who use index funds (and everyone should!) do so in part because their costs are so low... but also because they have learned the essential futility of trying to beat the market....
But that doesn’t mean the stock market is completely efficient.... On any given day, some stocks are overvalued while others are undervalued.... Thus, back in 1999, when Cisco Systems had, absurdly, the largest market capitalization in the world, it also had the biggest weighting in the Vanguard 500 Index Fund.... Indeed, it was the Internet bubble that really gave impetus to fundamental indexing. “I remember George Keane, the founder of the Commonfund, saying to me that there has to be a better way to index,” Mr. Arnott told me the other day. “We have people investing tens of billions of dollars in index funds and they are getting drawn into bubbles.” Mr. Arnott continued: “It was very clear what was wrong with the index was that the weight was linked to the price. If the price was wrong the weight was wrong.”...
When you talk to Mr. Arnott — as well as Mr. Siegel, speaking for Wisdom Tree — about why fundamental indexing seems to beat the market, at least on an historical basis, they offer several theories. One is that, by using a company’s fundamental measures to weight the stocks, their indexes are eliminating all the “noise” surrounding individual stocks that can cause them to become over or under valued.
Secondly... they are, in effect, tilting their weighting toward value stocks and away from growth stocks....
The real point of contention, however — and the reason this matters to investors — is that Mr. Arnott and Mr. Siegel make it sound as if their new indexing strategy is so far superior to traditional indexing that investors should abandon the latter for the former.... “It is not indexing,” insists Mr. Bogle. “It is a form of asset allocation, or active management strategy. It is being oversold as something it is not.”... According to Mr. Bogle, Mr. Arnott and the Wisdom Tree folks are trying to do what all active managers do: beat the market. And sometimes they will, and sometimes they won’t. But they are not going to match the market because their funds are not, ultimately, trying to replicate the market the way a cap-weighted index fund does...
The argument for indexing is that the average investor will receive the average return. Divide investors into four groups: (i) passive investors, (ii) active investors who know more than the average active investor, (iii) active investors who know less than the average active investor but think they know more, and (iv) active investors who know less than the average active investor and think they know less. Group (i) should index: they will receive the average return on average--and indexing is the way to do this with the least risk. Group m(iv) should index as well: if they don't index, they are the fools in the market--and they know enough to know that they are the fools. Group (ii) profit from their knowledge, inasmuch as group (iii) and those of (iv) who don't act on their knowledge of their own ignorance are their lawful prey--but everybody who thinks that he or she is in group (ii) should ponder hard whether he or she is in fact in group (iii) instead.
"Fundamental indexing" is a form of (ii): those who engage in it are active investors, and their informational edge--the thing they know that the average active investor doesn't--is that there are enough noise traders of group (iii) out there in the market that book or earnings or other fundamental weighting factors provide an easy way to take on the role of the house in the casino that is the stock market.
This is, I think, true--until there comes a day when there are enough investors following fundamental-indexation strategies that they become part of the least-informed half of active investors.
