Fundamental Indexing Becomes a Bit More Crowded

by: Richard Kang

First there was Rob Arnott and his firm, Research Affiliates, who now manage ETFs with a fundamental indexation strategy for PowerShares and Claymore. Then WisdomTree entered the market with their version of fundamental indexing although based on dividends while Arnott’s was a combination of dividends plus three other fundamental factors.

Now comes news of an ETF behemoth entering the market. Here’s the press release from State Street Global Advisors.

Let’s see. Here are the main points that I get out of this press release:

· “FTSE GWA index is one of a new breed of indices that weight stocks based on fundamental financial data rather than their relative size in the market”: FTSE is diversifying its non-market cap weighted indexation business. It already has the FTSE-RAFI indices with Rob Arnott and his group. The new FTSE-GWA indices seem to be direct competition to the FTSE-RAFI and not to WisdomTree’s indices.

· “…historic studies suggest that the strategy can be expected to outperform traditional market capitalisation indices by approximately 2 percent per annum over the long-term with similar or lower levels of risk.”: This sounds a lot like what Research Affiliates says. In fact, in John Mauldin’s book, he has a chapter dedicated to a discussion with Rob and the “2 percent premium”.

· “Wealth-weighted indices, by definition, hold greater weightings in securities with below-average price to earnings (or price-to-book or price-to-cash flow) ratios and are therefore considered “value” biased.”. This is followed up a couple of paragraphs down by this: “the weighting of individual securities is based on fundamental financial data — in this case earnings, cash flow and book value — rather than a security’s price and number of shares (market capitalisation).”: So SSGA focuses on 3 factors: earnings, cash flow and book value as opposed to Research Affiliates and their 4 factors of book value, income, sales and dividends.

· “…expects the product will co-exist peacefully with market cap indices, providing an interesting investment alternative.”: I have agreed with the idea of using very low cost market cap weighted ETFs along with some use of fundamental weighted ETFs.

I’m not sure what to think of this. Barclays Global Investors and SSGA have been the big gorillas in this industry from the beginning. Although having some big names like the Spyders (NYSEARCA:SPY), SSGA has basically lost the battle in the retail oriented ETF business. However, with its stated US$1.5 trillion mentioned at the bottom of the press release, “losing” hardly seems like the appropriate term. Certainly, like BGI, SSGA has a very substantial institutional business. But diversifying into fundamental indexation? This leads me to believe that Research Affiliates and WisdomTree are still so small that they might just not have the logistics and resources to tap the global megapensions and endowments who would be interested in this new innovation - or at least SSGA sees a window of opportunity as they already have the ear of many in the institutional space (at least more so than Research Affiliates). But that’s the institutional side.

What happens if SSGA decides to build products (ETFs) based on their fundamental indexation methodology for the masses. This could be an unforeseen problem for both Research Affiliates and WisdomTree. In the ETF market, “first to market” matters (think GLD versus IAU), but if SSGA enters the ring, it really would be a case of two Davids versus a supersized Goliath. I still am a supporter of Rob Arnott and his group. Frankly, his 4-factors just makes more sense than the alternatives and the numbers back it up.

[However, to make full disclosure, I have zero of my client’s assets in any form of fundamental indexation products. All our non-market cap weighted exposure is in funds managed by Dimensional Fund Advisors as we’ve been with them since 2003.]

I see no rush for me to add or change positions related to this discussion as I plan to wait and see how this new area develops. This news from SSGA is certainly interesting and if SSGA were to enter this specialized market, I would only see a “lowest cost” approach as a way to entice investors to consider their offering.

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