The Indexing Wars
It was so simple: Buy one fund that tracks the market. And hold it. Well, it's not so simple anymore
Thirty years ago, when the Vanguard Group launched its first stock index fund, Wall Street laughed.
Back then, indexing-an investment strategy that says you should buy and hold all the stocks in a market benchmark rather than trying to pick and choose the best shares-was considered a loser's bet. After all, if you're forced to hold both winning and losing stocks, by definition your gains will only be average (even though "average" can be quite profitable when the stock market is setting records, as the Dow industrials did in breaking 13,000 last week). Indexing was so reviled that the financial community dubbed it "Bogle's folly," referring to John Bogle, Vanguard's founder and one of indexing's biggest proponents.
Indexing prospered, though, and Bogle seemed to have had the last laugh. The fund he created, the Vanguard 500, is one of the nation's largest portfolios, with more than $120 billion in assets. A growing number of 401(k) retirement plans and 529 college savings programs are adding index funds to their mix. And over the past decade, index funds have consistently beaten actively managed portfolios, thanks in large part to their low fees and buy-and-hold approach. "Classic indexing is the winning strategy," Bogle says proudly.
But just as Bogle is declaring victory, along comes a new posse of critics-including Jeremy Siegel of the University of Pennsylvania's Wharton School, just down the road from Vanguard-who say old-fashioned indexers have it wrong. To be sure, these "fundamental indexers" embrace the virtues of buying and holding a low-cost index fund. But they don't like the way traditional index funds are constructed.
And now they are putting their academic theories to the test. By the end of last year, more than 40 fundamental index funds were on the market. This year several more have joined the fray, including three launched by Charles Schwab and six additional portfolios from the Siegel-advised WisdomTree Investments. Of course, that's just a fraction of the hundreds of traditional index products already out there.
So how do these newfangled index funds differ from the traditional model? And should you invest in one?
All index funds mimic a stock or bond market index. Traditional index funds attempt to track well-known benchmarks like the Standard & Poor's 500 index of blue-chip stocks or the Russell 2000 index of small stocks.
Weighty. But what most traditional indexes have in common is that they are weighted by market capitalization. The larger a stock is, based on the value that Wall Street gives it, the greater representation its shares will have in the index-and the more sway it will have over movements in the index. For instance, the largest stock in the S&P 500 right now is Exxon Mobil. And so it must be the biggest holding in the Vanguard 500 fund, which tracks the S&P, and have a great impact on the fund's performance.
What's wrong with that? Well, the fundamental indexers ask, what if Wall Street is wrong and Exxon Mobil doesn't deserve such a big slice of the pie?