The Religious War Over Indexing

Book review: The Fundamental Index: A Better Way to Invest

Passive investors are often passionate investors when it comes to what they think is right and wrong. For market cap or float-weighted indexers:

• The market is efficient!
• Keep expenses low!
• Don’t trade fund positions!
• Fundholders buy and hold!
• Tax efficiency!
• Weight by market cap or float!

For fundamental indexers:

• The market is inefficient (in specific gameable ways).
• Keep expenses relatively low.
• Adjust internal fund positions as valuations change!
• Fundholders buy and hold!
• Relative tax efficiency!
• Weight by fundamental value!

Some of the arguments in journals such as the Financial Analysts Journal have been heated. The two sides believe in their positions passionately.

For purposes of this review, I’m going to call the first group classical indexers, and the second group fundamental indexers. The first group asks the following question: “How can I get the average return out of a class of publicly buyable assets?” The answer is easy. Buy the same fraction of shares of every member of the class of assets. The neat part about this answer, is everyone can do it. The entirety of shares could be owned in such a manner. Aside from buyouts and replacements for companies bought out, the turnover is non-existent. Net new cash replicates existing positions.

The fundamental indexer asks a different question, namely: “What common accounting (or other) variables, relatively standard across companies, are indicators of the likely future value of the firm? Let’s set up a portfolio that weights the positions by the estimated future values.” Estimates of future value get updated periodically and the weights change as well, so there is more trading.

Now, not all fundamental indexers are the same. They have different proxies for value — dividend yield, earnings yield, sales, book value, cash flow, free cash flow, etc. They will come to different answers. Even with the different answers, not everyone could fundamentally index, because at some point the member of the asset class with the highest ratio of fundamental weight as a ratio of float weight will be bought up in entire. No one else would be able to replicate the fundamental weightings.

So, why all of the fuss? Well, in tests going back to 1962, the particular method of fundamental indexing that the authors use would beat the S&P 500 by 2%/year. That’s worth the fuss.

Now, I have kind of a middle position on this. I think that fundamental indexing is superior to classic indexing, so long as it is not overdone as a strategy. Fundamental indexing is just another form of enhanced indexing, tilting the portfolio to value, and smaller cap, both of which tend to lead to outperformance. It also allows for sector and company-level rebalancing changes from valuation changes, which also aids outperformance. In one sense fundamental weighting reminds me of Tobin’s Q — it is an attempt to back into replacement cost. Buy more of the assets with low market to replacement cost ratios.

But to me, it is a form of enhanced indexing rather than indexing, because everyone can’t do it. Fundamental Indexing will change valuations in the marketplace as it becomes a bigger strategy, wiping out some of its advantages. The same is not true of classic indexing, which just buys a fixed fraction of a total asset class.

Though the book is about fundamental indexing, and the intellectual and market battle versus classic indexing, there are many other topics touched on in the book, including:

• Asset Allocation — best done with forward looking estimates of earnings yields (another case of if everyone did this, it wouldn’t work.. but everyone doesn’t do it. Ask Jeremy Grantham…)
• The difference to investors between dollar vs time weighted returns by equity style and sector. (Value and Large lose less to bad trading on the part of fund investors… in general, the more volatile, the more fund investors lose from bad market timing.)
• A small section on assumptions behind the Capital Asset Pricing Model, and how none of them are true. (Trying to show that a cap-weighted portfolio would not be optimal…)
• And a section on how future returns from stocks are likely to be lower than what we have experienced over the last half century.

One more note: I finally got how fundamental weighting might work with bonds, though it is not explained well in the book. Weight the bond holdings toward what your own models think they should be worth one year from now. That’s not the way the book explains it, but it is how I think it could be reasonably implemented.

The Verdict

I recommend the book. The authors of The Fundamental Index: A Better Way to Invest are Bob Arnott, Jason Hsu, and John West. At 260 pages of main text, and a lot of graphs, it is a reasonable read. The tone is occasionally strident toward classic indexing, which to me is still a good strategy, just not as good as fundamental indexing. (It sounds like Bob wrote most of the book from a tone standpoint… but I could be wrong.)

Summary

This book is for academics interested in the debate, and buyers of indexed equity products. It is well-written, and ably sets forth the case for fundamental indexing.

If you are interested in the topic of of indexing, buy the book, and if you buy
it through the links above, I get a small commission. (If you buy anything through Amazon after entering from a link on my site, I get a small commission. That’s my tip jar, and it doesn’t raise your costs at all.)

Comments

[SaberJim]

David,

Nice review. One question I have about the book. Does it give a fairly detailed explanation of how fundamental indexing is implemented?

Long time , classical indexer (except for BRKA), Thanks.

[mydoghatescats]

Why would fundamental indexing get priced and stop working but not market cap indexing?

Every single fundamental investor who gets the efficient market religion and converts to the efficient market faith, subtracts one investor from the pool of price determinators. Taking this to its logical conclusion, suppose everyone gets this religion? Who would then be doing the analytical based, fundamental valuing and head-scratching that, writ large, prices all things knowable into stocks? A growing congregation of EMH converts and passive, market-weighted indexers, will render markets, and these indexes, more inefficient.

We already saw a good recent example of this phenomena at the end of the last decade. Many people saw how well they could do by simply buying the S&P Index as a shrinking number of stocks, Ciscos, Microsofts, and Oracles, came to dominate that index. It was a crazy time where many factors led to these huge pricing inefficiencies, but indexing contributed its part. Every new $1000 that came pouring into say, the Vanguard 500 fund, meant that Gus Sauter, the manager of these funds, had to buy disproportionately more of these bloated stocks, bloating them further. Value stocks tanked so badly during this time that value managers were leaving the field or getting fired for underperformance.

So of course, as fundamental indexing becomes popular, and popular it will be, they will not come into their 15 minutes of fame without introducing similar inefficiencies. However they construct these indexes, demand and prices will rise for the issues most heavily weighted, demand and prices will fall for the issues least weighted or not included at all.

Personally I believe fundamental indexing is going to be huge. I think for awhile the fundamental wind will be at their back. Then the same information cascade that caused market-weighted indexing to do so well in the 90s will begin to feed into the equation, giving them a further assist, then the game will be up until people forget all about it.

You could say that whenever you get more folks doing fundamental stock analysis you are enabling efficient markets and passive, market-weighted indexing. Conversely, whenever you get more folks investing in passive, market-weighted indexing, as if markets were efficient, you are rendering the process of fundamental stock analysis, and fundamental indexing, more valuable. This phenomena will of course be most evident at extremes of adaptation, but logically at least it would seem to be happening at the margins, always.

[mydoghatescats]

It's not my idea of a Saturday well spend, so I have hardly scratched the efficient market academic literature. I am sure that probably this paradox has been addressed. But if not I lay claim, giving it this name:

Mydoghatescat's Fundamental Paradox Of The Efficient Market Hypothesis

[LiquidSoapDispenser]

"Saturday well spend"? "Sure that probably"?

Huh?