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Jonathan Clements reviews Robert Arnott's work on fundmantal indexes in a recent Getting Going column in the Wall Street Journal. Arnott argues that weighting indexes by market cap - the methodology used by almost every index mutual fund and ETF - is flawed and leads to inferior performance. Arnott's work was covered a few months ago on ETF Investor; you can read about it here, and a critique of it here. Meanwhile, Pimco launched a fundamental weighted index fund in May, called the Fundamental IndexPLUS TR Fund. And PowerShares Capital Management has announced that later this year it will launch a fundamental weighted index ETF. With that background, Jonathan Clements makes three points in his article:

  1. The expenses of the fundamental-weighted funds are signficantly higher than traditional ETFs and index mutual funds. The PowerShares ETF, for example, will have an expense ratio of 0.6%, and the Pimco fund charges 1.14% in annual expenses for its no-load D shares.
  2. The fundamental indexes outperformance may be a function of the recent outperformance of small cap and value stocks. This is a similar (though less rigorously argued) point that made on ETF Investor earlier.
  3. Investors who chase performance may end up buying high and selling low. Arnott's funds beat the S&P 500 over the last 43 years, but underperformed in 1998-1999 by 23 percentage points cumulatively.

The entire WSJ article is here (paid subscription required).

One key point that Mr Clements doesn't make is that market cap weighted indexes are by far the most efficient way to invest in terms of taxes and trading fees. With a market cap weighted index, changes in stock prices in the underlying index don't result in changes to the fund's composition. If a stock rises, for example, its weighting in the index rises. That's the reason why market-cap weighted indexes have such low turnover. And low turnover means low trading costs and low realization of capital gains taxes.

In contrast, any other metric for constructing an index will result in higher turnover. As stock prices change, the fund manager will have to rebalance the index in line with the fundamental weightings. That would lead to higher portfolio turnover, higher trading fees and a higher tax bill.

Mr Clements' lack of concern about tax issues is perhaps due to an assumption that most people use tax-sheilded accounts such as IRAs and 401-Ks for most of their investing. That would also explain his consistent advocacy of Vanguard index mutual funds over ETFs. He argues (correctly) that investors need to be careful of the trading commissions and spreads on ETFs, neither of which are payable on purchases of index mutual funds. But he tends to discount the fact that Vanguard's index mutual funds (and Vanguard's own ETFs) are less tax-efficient than standard ETFs. (See Herb Morgan's article on this, The Problem With Vanguard VIPERs ETFs.)

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Source: Rob Arnott and Fundamental Indexes Revisited (ETF: PRF)