Fundamental Indexing: Checking In on the New Paradigm

A few years ago, I met a former colleague for lunch. He had just come from a conference where he heard Research Affiliates' Rob Arnott describe his new "fundamental index" philosophy, and he was quite excited about it.

For the uninitiated, Rob Arnott and Wharton professor Jeremy Siegel are two of the best known advocates of alternative indexing strategies. Traditional stock market indexes are weighted by a stock's market capitalization -- its price-per-share multiplied the number of shares outstanding. Thus, these indexes, like the S&P 500 or the Dow Jones Wilshire 5000, are dominated by the largest firms in America.

Siegel and Arnott argue that indexes weighted by market capitalization are inefficient and prone to bubbles. And there's no denying that as the stock prices of some companies can seemingly lose touch with reality from time to time (think Yahoo! or AOL/Time Warner during the Internet bubble), causing their representation in market-cap weighted indexes to grow rapidly. When these firms fall from favor and their stock prices decline, they drag the return of the index down with them.

To minimize that problem, Arnott and Siegel have each (separately) developed indexes that weight companies by factors other than market capitalization. Arnott's Reseach Affiliates uses a proprietary mix of sales, cash flow, book value, and dividends to weight the corporations in their RAFI® Indexes. Siegel's firm, WisdomTree, weights their index funds by dividends and earnings.

Investment products tied to each approach were launched a few years ago to great fanfare. In a June 2006 Wall Street Journal op-ed, just two days before WisdomTree's first ETFs were launched, Siegel claimed that this new approach to indexing represented a "revolution ... a new paradigm." "[I]t is possible," he wrote, "to construct broad-based indexes offering investors better returns and lower volatility than capitalization-weighted indexes." (Emphasis added.)

Arnott was equally exuberant, citing 42 years worth of back-tested data that showed that his approach to indexing had outperformed the S&P 500 by more than two percent annually. (Funny how no one ever launches a new fund citing back-tested data that had underperformed the index, but I digress.) PowerShares launced a handful of exchange-traded funds based on Arnott's fundamental-weighted RAFI® indexes; and Schwab offers five mutual funds using the indexes.

If you've followed the mutual fund industry at all, you could have probably predicted what happened next -- the funds have failed, thus far, to live up to their considerable hype. Through March, the largest PowerShares Fundamental Index ETF, the FTSE RAFI US 1000, has lagged Vanguard's capitalization-weighted Total Stock Market ETF by 3.3 percent year-to-date, and by 2.6 percent over three years. WisdomTree's flagship fund, the LargeCap Dividend ETF, hasn't done much better, trailing the S&P 500 by nearly 3.2 percent year-to-date, and by 1.7 percent since its inception.

Of course, we're looking at a very short time period. But investors in these funds might fairly be wondering what happened, particularly because these strategies were touted as offering not just better returns, but less volatility than their traditional cousins.

What happened is that both Arnott's and Siegel's approach to indexing provides a considerable tilt toward value stocks (which typically pay higher dividends than growth stocks). When value stocks do well relative to the total market, as they did in the early part of this decade, these funds will -- presumably -- fare well. But when value stocks lag the total market, as they have recently, these funds will lag, too.

Like many others (including MoneyWatch colleague Lynn O'Shaughnnessy) I've always been skeptical of the marketers of these new indexing products -- for better or worse, the claims made by Siegel and Arnott struck me as little different than those made by the marketers of technology funds in 1998, a bit over the top. (For instance, consider Siegel's assertion above in his Wall Street Journal piece, in which he claims that his new strategy provides better returns. More accurately, back-testing showed that his approach has provided better returns in the past.)

No matter how many years of back-tested data one is able to unearth to support a particular approach to investing, this simple fact remains: If you construct a portfolio that strays from the overall market portfolio -- represented by a market-capitalization weighted total stock market index -- you are making a bet against the market.

Regardless of whether you're overweighting value stocks, health care stocks, or pork bellies, there is no guarantee that the past will look like the future, and that you'll be rewarded for your bet. Indeed, you run the very real risk of earning inferior returns over the long-term, particularly if the cost associated with your strategy is significantly higher than the cost of a total stock market index fund.

At that lunch a few years ago, my friend was disappointed to hear of my skepticism. He compared me to the dowdy old finance professor, whose belief in efficient markets was so strong that he wouldn't stoop to pick up a $20 bill off the ground, figuring that if it was real, it would have been scooped up already.

No, I told him, I would indeed stoop to pick up a $20 bill. But unlike Rob Arnott and Jeremy Siegel, I wouldn't then suggest that others should quit their jobs and try to make a living finding $20 bills on the ground. But one man's good fortune is another's new paradigm, I suppose.