The Indexing Wars
It was so simple: Buy one fund that tracks the market. And hold it. Well, it's not so simple anymore
What's more, some skeptics question the timing of the launch of fundamental index products-contending that it coincides with a favorable environment for such an approach.
A traditional market-cap-weighted index fund tends to favor larger stocks and growth-oriented stocks, strategists say, based on the momentum of the market. By contrast, because fundamental indexes resist the market's swings, they tend to favor smaller stocks and value-oriented shares.
Well, as luck would have it, value stocks and small stocks have been leading this market for the past five years. Yet today, after a huge run-up, small- and mid-cap stocks and value stocks look much frothier than they did at the start of this decade. In fact, says Sonya Morris, editor of the Morningstar ETF Investor newsletter, with the resurgence of large stocks and growth-oriented shares this year, "now may be just the wrong time to abandon traditional indexing."
Cruise control. Yet outperforming a traditional index isn't the only reason to consider a fundamental index fund or ETF, says Matt Forester, vice president and portfolio manager of Cumberland Advisors. Investors must also consider risks and volatility, he says, and fundamental indexers say their products produce a smoother ride.
Cumberland is using some new index investments run by WisdomTree and PowerShares in its client portfolios. But Forester says Cumberland hasn't abandoned traditional indexing, in part because it wants to track the longer-term record of fundamental index funds.
The rise of fundamental indexing can be seen as a victory for indexing: The strategy is so broadly accepted that financial firms need to come up with new products to satisfy investor demand.
But in another way, the indexing wars are a defeat for the strategy. That's because one of the best reasons to index is to simplify your life. Why bother trying to pick the best mutual fund, which in turn will try to pick the best stocks, when you can simply own the entire market through a single fund?
Now, however, indexers have to make a series of choices: Which school of indexing do I believe in? If it's fundamental indexing, which factors do I trust-earnings or dividends, for example? And which fundamental index provider is best-Rob Arnott, Jeremy Siegel, or someone else?
Backers of fundamental indexing say they want the market to make that decision. Of course, that's the same market that fundamental indexers say can't be trusted to properly value stocks.
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