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Debating 'Fundamental Weighting' and Indexing [view article]
The debate is moot considering the basic objective of the two types of funds are like comparing chickens to roosters. Your average Index fund, S&P, Russel, or any other is based on incresed valuation. Your basic fundamental indexing ETF is based on income producing yield. The best move for the average investor is to place the fundamental index funds in a tax deferred account, Roth IRA, Trad IRA, or 401 and grab the yields. Investing in traditional index funds could go either way in a tax deferred account or an open account. Diversity is still the key to making money. Replyts
Debating 'Fundamental Weighting' and Indexing [view article]
Assembling portfolios of companies ordered simply by the price a market has assigned them is perfectly fine as A method of assembling an index. But to give this method some sort of primacy seems self-evidently irrational.If you needed to buy 10 hens once a year, you probably you would do okay by simply going to the market, finding the 10-chicken-pen that the market has assigned the greatest value to, and buying those chickens, year in and year out.
But what if you went back to the market one year and, in addition to just the market price, each pen had another number which was the egg yield: the number of eggs laid during the past year divided by the market price? And another number: new chickens hatched divided by the market price?
In the former case the market has looked at all the pens and assigned each a value. This value is based part on past performance and part of future expectations. But you have no information how much of the value is based on actual performance and how much is based on expectations. In this case you have information about the entity, the chicken pen, but this information is secondary, derivative. The price is reflective of the value of the chicken pen, but it is not the value.
In the latter case you still have this secondary, derivative information of market price assigned. But now you have additional information, and this data is primary to the object itself: egg production and fertility numbers.
Instead of calling it a market cap index it really should be called a "high hopes and expectations" index because, though analysis on the hard fundamental data is part of the price assignation, no effort is made to order market-cap weighted indexes on anything other than that: market value. In this sense these types of indexes are ordered, by varying degrees, on the hopes and prayers of market participants.
Ordering hens or stocks in accordance with more objective performance measures does not totally expunge the index of hopes and prayers. You are basing this ordering on past performance in the hopes that past is predictive, which often it is not. But there is no doubt less hoping and praying, and therefore more science, inside a fundamental index than inside a cap-weight index.
There is indeed the problem that ordering indexes on fundamentals introduces overweighting to certain sectors, and these, and other problems, need to be addressed. But as we saw during the last great bubble, there were huge overweightings that happened inside of market-cap weighted indexes as well. What got overweighted was euphoria, irrational exuberance, and stocks getting priced higher and higher, growing more and more "valuable" simply because they kept going up and up, until many of the high priced chickens got their heads chopped off, ran around a little more, ran off a cliff, or simply keeled over, and died.
Buying a market-cap weighted index isn't as uncertain as buying 2 chickens in a bush, but more uncertain than buying a fundamentally-weighted index, which is closer to buying 1 chicken in hand.
We are always to some degree, even inside an index, picking stocks. There is a lot of slicing-and-dicing silliness going on around indexing, and more to come, but ordering and packaging securities in accordance with fundamentals such as earnings, sales, book value, or dividends is a valid way to construct an index. To do so is no less valid than ordering an index in lockstep to the values assigned to securities by a herd. Market herds can be smart, and most of the time correct, but sometimes they do stupid things. An index doesn't have to be constructed to slavishly follow them everywhere, even over a cliff, to be correct. Reply
Considine
Debating 'Fundamental Weighting' and Indexing [view article]
Nice article Dr. DeLong! I find the whole debate on this issue rather odd. The primacy of market cap weighted indices hinges on a strong version of market efficiency. Fundamental advocates point out a body of evidence that fundamental weights such as low P/E have historically led to high performance. Frankly, I find the market cap weight folks the more odd: they are pushing for the idea of strong market efficiency despite enormous evidence to the contrary.To suggest that market cap weighting is 'indexing' while some other weighting is 'active' is strange. Both rely on a fairly arbitrary assumption about how to weight assets. Market cap weighting will have less turnover, which is good, but is not enough to make the case that this is the 'best' way to create a portfolio in an asset class.
My biggest issue with fundamental indices is the way that they are promoted. Filters on fundamental value have resulted in high concentrations of certain asset classes. The dividend-focused approach tended to result in high exposure to financials, for example. Many investors did not really understand this.
Mr. Bogles comments quoted in this article are correct, but I also find Mr. Bogle's long-term insistence that it makes good sense to own at market cap weight is not compelling.
Cheers,
Geoff Reply
ts
Debating 'Fundamental Weighting' and Indexing [view article]
Irony: if or when everyone in the world adopts the efficient market religion and simply buys an index fund, the market will be maximally inefficient because there will be nobody left doing the head scratching analysis that supposedly renders the market efficient in the first place. So there is a symbiotic relationship between active and passive investors. Both need the other to make their version of extracting returns from the market possible. More passive investors means less stock analysis means more market inefficiency. More active investors means information is more fully, more quickly, priced, means more market efficiency. Stock pickers need indexers. Indexers need stock pickers. Both make the other's world go round. ReplyDebating 'Fundamental Weighting' and Indexing [view article]
"Fundamental Indexing" is just a bassackwards way of saying they're running a large, slow-trading, mechanical quantitative equity fund.Not that there's anything wrong with that style of trading! It's great, especially for a fund seeking relative outperformance, to be holding stocks with fundamental or valuation "anomalies," but let's call a spade a spade, it's *mechanical trading.*
I object only to the marketing aspect of its name. Reply
Shriver
Debating 'Fundamental Weighting' and Indexing [view article]
Good article. Good points. Thank you. ReplyWhy Fundamental Indexes Lagged Cap-Weighted in '07 [view article]
I can't help but think of John Bogle's comment that, over time, growth and value will have their own turns in the financial wilderness (or in the sun), and therefore costs should be the overriding consideration.The Powershares FTSE RAFI funds are expensive at >70 basis points. The WisdomTree funds are better priced, but they still can't beat Vanguard's <20 basis points. The idea of fundamental weighting makes a lot of sense to me, but those expense ratios make me hesitate.
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Editors
General Discussion on PRFM
Is this a buy or a sell? ReplyNusbaum
Why Fundamental Indexes Lagged Cap-Weighted in '07 [view article]
J Copp, I don't really know. i do know that so far DEM has lagged ADRE (a broad based ETF I use for clients and own personally) so maybe so.Personally i like the idea of an ETF and a couple of individual stocks for EM exposure. I picked ADRE a long time ago prefering it to EEM. That is has beaten DEM might just be luck?
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Why Fundamental Indexes Lagged Cap-Weighted in '07 [view article]
I agree. I believe it is to one's peril to ever under estimate the long term power of fundamentals. ReplyWhy Fundamental Indexes Lagged Cap-Weighted in '07 [view article]
Roger:Good article. Would this mean that Fundamental Weighting would not work as good in Emerging markets in your opinion?
John Reply
Nusbaum
Why Fundamental Indexes Lagged Cap-Weighted in '07 [view article]
yes, depending on how much of an overweight you mean. also, if you read the IU piece you will see that foreign did not have the same result ReplyWhy Fundamental Indexes Lagged Cap-Weighted in '07 [view article]
Isn't this also a problem generally overweighting with dividend paying stocks? ReplyNusbaum
Why Fundamental Indexes Lagged Cap-Weighted in '07 [view article]
thanks for the kind word.your first question...yes in a normal cycle small cap leads at the beginning (it leads for most of the cycle actually) and then gives way to large cap at the end, like 1999 or 2007. This has to do with the willingness to assume more risk earlier in the cycle.
I don't think a fund being overweight financials (or some other sector) is what matters. What I think matters is that if you own a fund that is very overweight a sector then the rest of the portfolio needs to compensate for that overweight. Reply
Guy
Why Fundamental Indexes Lagged Cap-Weighted in '07 [view article]
Forgot to say: love your articles, Roger. Reply