There’s a well-written article in the New York Times on the growing debate over market-weighted vs. fundamental-weighted indexes. The author Joe Nocera has done an exceptional job distilling a complicated topic into an easy-to-understand article.
If you have 5 minutes you should read the New York Times article. If you only have 30 seconds here’s the 30-second version:
The world has been using market-cap weighted indexes. The weight of each company in the index depends on its market capitalization. Bigger companies have a greater weight in the index.
Some believe that traditional market-cap weighted indexes overweight overpriced companies and therefore result in subpar returns. Over the last few years there has been a growing movement that advocates the use of fundamental measurements (e.g. earnings, dividends, etc.) to determine each company’s weight in an index. They have developed not only dozens of indexes, but also dozens of funds following such indexes. They argue that the new funds generate superior returns over traditional market-cap weighted funds.
Robert Arnott, an advocate of fundamental-weight indexing: “It was very clear what was wrong with the index was that the weight was linked to the price. If the price was wrong the weight was wrong.”
Opponents of the new movement complain that it’s not true indexing because it doesn’t seek to obtain the market return. They claim it’s nothing more than a clever marketing scheme for what amount to actively managed funds.
John Bogle: “The market return is the market return.”
Bruce Greenwald, Columbia University finance professor: “It is a crime that they are marketing this as some kind of new theory they’ve come up with. All they are doing is dressing up a simple, well-understood practice.”
Supporters of the new movement (in no particular order):
- Robert D. Arnott
- Nobel laureate Harry Markowitz
- Charles Schwab
- Jeremy Siegel, well-known Wharton economist
Supporters of the traditional market-cap weighted indexes (in no particular order):
- André Perold, finance professor at Harvard Business School and a Vanguard director
- Vanguard founder John Bogle
- Burton Malkiel, author of “A Random Walk Down Wall Street”
- Clifford Asness, co-founder of AQR, a large quantitative hedge fund
- Bruce Greenwald, Columbia University finance professor
My Thoughts
I need to research the issue before I come to any firm conclusions. But I’ll offer a few thoughts.
I sympathize with the view that traditional cap-weighted indexes can become skewed when stock prices are out of balance. Also, I’ve long thought that a 500-company or a 3000-company market-weighted index is overkill when the top 20% of the index drives 90% of the index’s movement (that’s not a criticism of traditional cap-weighting, just a pet peeve).
I like the idea of indexing based on something other than market capitalization. However, fundamental indexing has the potential to introduce a great deal of subjectivity. The whole point of index investing is to minimize the need for subjectivity.
To the extent an index is based on subjective measurements, it seems like nothing more than a clever marketing strategy for active management (for now we’ll leave aside the fact that there is already some amount of subjectivity in many popular market-weighted indexes, including the S&P500. Topic for another day).
But if the index is based on something more objective, like earnings (and nothing else), I don’t have the same objection. Note that one of the fund companies mentioned in the article uses earnings to weight their indexes, while the other uses a combination of earnings, dividends, and other fundamental variables. There’s little or no subjectivity in the former, but a lot of subjectivity in the latter.
I love innovation and new financial products. I don’t use most new products but I like that they’re available for research and for possible use if I decide it’s a good fit at some point. I plan to watch the fundamental index funds for a while and see if they make sense for me.