Battle For The Index Investor

A war of words is raging over how best to weight an index fund. At stake, lots of fees

Nobel Laureate William Sharpe has called indexing "a dull, boring way to be a better investor than many of your friends." Forget dull and boring. A civil war has broken out in academic journals, blogs, and op-ed pieces penned by the titans of indexing.

The upstart Fundamentalists say new, customized indexes based on metrics such as dividends, earnings, and book value -- now available as exchange-traded funds (ETFs) -- best traditional benchmarks like the Standard & Poor's 500-stock index and the Russell 1000. Quant guru Robert Arnott of Research Associates and Wharton School professor Jeremy Siegel, author of Stocks for the Long Run, are leading Fundamentalists. The Traditionalists, such as John Bogle, the founder of Vanguard Group, and Princeton University professor Burton Malkiel, author of A Random Walk Down Wall Street, are appalled by the Fundamentalists' claims. Siegel says that custom indexes reflect "a new paradigm" for understanding how markets work. Bogle retorts: "The new things aren't indexes at all."

The dispute is arcane, infused with theoretical disagreements about modern portfolio theory. Still, it's a struggle over which indexes will earn investors the biggest return for the least risk and, of course, which companies will reap the rewards. Vanguard is the giant in traditional indexing, while Arnott's custom indexes are marketed by PowerShares Capital Management and others. Siegel is senior investment strategist for Wisdom Tree Investments, which also sponsors fundamental ETFs.

The details are in index construction. Traditional indexes like the S&P and Wilshire 5000 are capitalization-weighted, meaning the heft of each stock in the index is relative to the market value of its shares. In practice, that means the most highly valued companies wield a disproportionate influence on performance. These indexes can become lopsided. During the height of the dot-com era, technology stocks accounted for more than 30% of the index, about double its historic average. That turned out to be a serious drag on returns when the bubble burst.

MARKET MOOD SWINGS

The capitalization-indifferent fundamentalist approach is less susceptible to market mood swings and comes closer to ranking companies on their importance in today's economy. For example, PowerShares' FTSE RAFI 1000 Portfolio (PRF) places Wal-Mart Stores (WMT ) and General Motors in the top 10 holdings, though neither is that high in the S&P 500. Simulations by Arnott and others suggest that the fundamental indexes beat the traditionals by about two percentage points a year over 40 years. The Traditionalists argue that the new indexes are benefiting from a market now favoring value and small-cap stocks.

A more compelling criticism is the higher fees and trading costs. For instance, Vanguard's Total Stock Market (VTI ) ETF (VTI) sports annual expenses of 0.07%, while the Wisdom Tree Total Dividend Fund (DTD), based on dividends, has a 0.28% cost. PowerShares' RAFI FTSE US 1000, which weights stocks based on sales, income, dividends, and book value, costs 0.76%.

In the end, this argument may be a lot of hot air. Most investors have both traditional index funds and actively managed mutual funds. Expenses on the pricier ETFs are only half that of the average mutual fund. If fundamental indexes catch on, it could be at the expense of managed mutual funds, not traditional indexers.

By Christopher Farrell

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