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?
"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.
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.
This story appears in the May 7, 2007 print edition of U.S. News & World Report.