The Indexing Wars
It was so simple: Buy one fund that tracks the market. And hold it. Well, it's not so simple anymore
"I was a very big fan of cap-weighted indexing-that is, until I began to see the strains of real events," says Siegel, the Wharton finance professor who is a director of WisdomTree.
Siegel uses the stock market of the late 1990s to show what he thinks is wrong with traditional indexing. Investors caught up in the Internet bubble bid up the price of technology stocks to often ridiculous heights, until the tech sector accounted for more than a third of the entire S&P 500. So, if you owned an index fund in 1999, your fund's stake in tech names like Cisco Systems or Intel was huge-just in time for the bubble to burst. And investors in a traditional S&P500 index fund endured losses of nearly 50 percent from the bull market's peak in March 2000 to the subsequent trough in October 2002.
By contrast, says Jeff Mortimer, head of equity portfolio management at Charles Schwab, fundamentally weighted indexes wouldn't have bet so heavily on tech in the late '90s. And they wouldn't have lost so much in the bear market of 2000. "I think a lot of people wouldn't have minded leaving some money on the table if it could protect them from the bear that ensued over the next three or four years," Mortimer says.
The bursting of the bubble highlights the fact that "a market-cap-weighted index will always overweight stocks when they are overvalued by the market and will always underweight undervalued stocks," says Rob Arnott, chairman of the investment management firm Research Affiliates.
Fundamental indexers like Siegel and Arnott say there's a better way. Instead of relying strictly on what the market thinks a stock is worth, they believe indexes should be constructed based on fundamental factors like companies' dividends or earnings.
Arnott's firm has created a new family of Research Affiliates Fundamental Indexes, or RAFI, that track domestic and foreign markets. These new benchmarks select and weight stocks based on a combination of a company's sales, dividends, cash flow, and book value. They're being used to manage some index mutual funds run by Schwab and exchange-traded fundsrun by PowerShares. (An exchange-traded fund, or ETF, trades like an individual stock but represents a diverse basket of securities like a mutual fund.)
Arnott back-tested data on his RAFI 1000 index of large U.S. stocks and says that between 1962 and 2006, his fundamental index gained 12.5 percent annually. By comparison, the S&P 500 advanced just 10.4 percent. Plus, the RAFI 1000 was less volatile.
But Bogle protests. Instead of comparing the theoretical performance of one index versus another, he says, it would be more fair to compare the performance of funds that track those indexes, after all fees and trading costs are taken into account.
Bogle points out that many of the new fundamental index funds charge higher fees than traditional index funds do. For example, his Vanguard 500 index fund has an annual expense ratio of 0.18 percent, which means that for every $10,000 you invest, Vanguard will take out only $18 a year in fees. Schwab's new fundamental index funds charge between 0.35 percent and 0.59 percent in fees, depending on how much you invest. And WisdomTree's large-cap index ETFs are charging 0.28 percent.
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