Tuesday, September 11, 2007

Fundamental vs Cap-Weighted Indexing Debate

I have written many times about moving along with better investing, thinking about long-term themes that will improve your investing results.

One of those themes, for passive investors, is to use low-cost products, like ETFs or index mutual funds. For the average investor, this will produce better than average results. Another theme is to use those same type of products that mirror some type of fundamental, as opposed to capitalization-weighted index.

John Bogle's (creator of the Vanguard mutual fund behemoth) back-testing research several decades ago that showed that most investors would be better off in funds that simply mirrored the then best market indices available, but at the lowest cost. However, times move on, research advances and other indices are created and tracked.

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The ones that are outperforming the conventional capitalization-weighted indices (like the S&P500, the Dow Jones Industrials, etc.) are ones that track fundamentally-weighted indices. Products, such as low-cost ETFs, are then modelled on those indices. Some of the indices or products are the RAFI indices, and the Wisdom Tree series of products.

RAFI indices consider the economic footprint of the companies it tracks (rather than it's stock market value) and in back-testing, those indices generally outperform the more popular by a significant margin. They've also generally outperformed since various products modelled on them have been produced over the past several years. The Wisdom Tree series of products generally looks at the dividends paid as a fundamental weighting, and models products based on that. Notwithstanding its weakening relation to companies that outperform the average capitalization weighted index, it is still a decent predictor of outperformance.

Anyone wanting to understand this further can go to a debate among three leading proponents of the various styles - Rob Arnett for RAFI indices, Jeremy Siegel for Wisdom Tree, and Gus Sauter, Chief Investment Officer for Vanguard - here.

An interesting and enlightening debate, and well worth the read. I have also written about fundamental indexing here, and here.


The Confused Capitalist

1 comment:

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