I found this article titled "Passions Run High on Indexing" pretty funny.  Why?  Because it's about a bunch of really smart guys -- including Arnott, Bogle, Siegel, and a couple professors -- arguing about fundamental indexing.  Why is that funny?  Because it reminded me of the active/passive debates on this forum.

In the end, they are all just a bunch of jackasses like us, except they have a lot more dough.  Except for the professors, of course.

Petrocelli 

[Note: Edited to fix link.]

This is a great article.  Petrocelli's link didn't work for me.  Try THIS LINK HERE.

Essentially, the article is about indexing - but not cap weighted index. The problem with cap-weighted indexes is that you get sucked into bubbles - like the Tech bubble or Credit bubble - and then lose your shirt when it pops.  That's why so many indexes have zero returns for the decade.  Not good.

Snippet:

By 2005, by which time Mr. Arnott was both marketing fundamentally weighted indexes and promoting their “profound” (his word) implications in the pages of The Financial Analysts Journal, his company had devised a much more complex weighting system, using revenue, earnings, dividends and book value. (Wisdom Tree, which markets more than three dozen fundamentally weighted exchange traded funds, uses a much simpler formula: its international E.T.F.’s use dividends, and most of its domestic index funds are earnings-based.)

Many indexing proponents argue that you just want to "buy the market" - and avoid paying for incompetent active management. 

The big question is: "What the hell is 'the market'?" 

Personally, I've never bought the theory that the market is represented by cap size.   

But, if someone devises a "more complex weighting system" - incorporating things like profits, dividends, growth rates, book value, etc - can you find agreement that this represents the market?  Or, did someone just invent a personal trading / weighting system?

Great article!  This goes to heart of the passive / active debate.

Doesn't deep S&D accomplish almost he same thing...

Hi Petro,

It seems to me it is not the method that is being criticized, but the marketing. The article didn't get into the weightings of the fundamental indexes, and whether the return was increased due to higher weightings of small and value stocks.

Why would anyone want a fundamental index over a value index? The value index uses different metrics than simple P/E, but actually goes a step further and buys lower cost stocks.

You are right, it is funny, but it is funny because it is irrelevant. The active -vs.- passive is also irrelevant. What is important is whether or not the index would offer anything over tilting a portfolio in the direction you wanted to tilt it. The fundamental index -vs.- the S&P 500 is like comparing small caps to large caps or value to growth.

You could probably accomplish the same results by simply investing in the mid cap index fund, an avenue that is already available, and most likely at a lower price.

It is also not a cure-all for market bubbles, as when the bubbles burst, and large cap businesses suffer, the whole market suffers, as the large cap businesses support the market, both US and international.

Smaller caps and value businesses just do not suffer as much after a pure pricing bubble such as 2000 - 2002, but more so in other bear markets. I agree with Phil DeMuth (and Ben Stein); we will probably not see another bubble like that one in our lifetime.

Chasing after a cure for the pricing bubbles may be a day late and a dollar short.

What we need to concentrate on now is what the next bear market might look like.

Chin

[quote user="chinwhisker"]

Why would anyone want a fundamental index over a value index? The value index uses different metrics than simple P/E, but actually goes a step further and buys lower cost stocks.

[/quote]

Hmmm.  I wonder why the Vanguard Value Index fund has performed so poorly.  Look HERE.  It has scarcely outperformed the S&P 500 fund.

Maybe it would be worthwhile to look at the idea of a fundamental index more carefully? 

Plus, I'm not convinced that the current bear market is over. 

[quote user="chinwhisker"]

Why would anyone want a fundamental index over a value index? The value index uses different metrics than simple P/E, but actually goes a step further and buys lower cost stocks.

You are right, it is funny, but it is funny because it is irrelevant. The active -vs.- passive is also irrelevant. What is important is whether or not the index would offer anything over tilting a portfolio in the direction you wanted to tilt it. The fundamental index -vs.- the S&P 500 is like comparing small caps to large caps or value to growth.

You could probably accomplish the same results by simply investing in the mid cap index fund, an avenue that is already available, and most likely at a lower price.

Chin

[/quote]

Hi Chin...I'll give you one reason you did not cite; perhaps you are unaware of this key point.  When it comes to investing in international stocks, a key concern is the lack of visibility, openness, opaqueness, and good accounting that can be relied upon.  A lot of smoke and mirrors exists with foreign equities.  By insisting on a dividend being paid, one is better assured the company is for real, and has real earnings.  So a dividend tilt, to me, makes a lot of sense in international investing.  Will this play out, we'll see.  But it is one reason I own some Wisdom Tree ETF's.  So far, so good.  And if it doesn't play out, then I don't see too much variation from a straight market cap value international index anyway.  It's not a huge risk versus traditional indexing.

BTW Petro, thanks for article.

retired at 48

 

[quote user="norbertc"][quote user="chinwhisker"]

Why would anyone want a fundamental index over a value index? The value index uses different metrics than simple P/E, but actually goes a step further and buys lower cost stocks.

[/quote]

Hmmm.  I wonder why the Vanguard Value Index fund has performed so poorly.  Look HERE.  It has scarcely outperformed the S&P 500 fund.

Maybe it would be worthwhile to look at the idea of a fundamental index more carefully? 

Plus, I'm not convinced that the current bear market is over. 

[/quote]

Hi Norbert,

The reason Vanguard's value fund follows the S&P 500 closer is it only uses the lower half of the S&P 500. DFA or Rydex would have worked better in the 2000 - 2002 bear market, but maybe not so in other bear markets. The same would hold true for fundamental indexing as it also adds size risks to the equation.

Whether the bear market is over or not, we are not facing another pure value bubble bursting. The P/E of the S&P 500 is half of what it was before it burst, and around the average of the post war period.

Chin

[quote user="retired at 48"]Hi Chin...I'll give you one reason you did not cite; perhaps you are unaware of this key point.  When it comes to investing in international stocks, a key concern is the lack of visibility, openness, opaqueness, and good accounting that can be relied upon.  A lot of smoke and mirrors exists with foreign equities.  By insisting on a dividend being paid, one is better assured the company is for real, and has real earnings.  So a dividend tilt, to me, makes a lot of sense in international investing.  Will this play out, we'll see.  But it is one reason I own some Wisdom Tree ETF's.  So far, so good.  And if it doesn't play out, then I don't see too much variation from a straight market cap value international index anyway.  It's not a huge risk versus traditional indexing.[/quote]

Hi Ret48,

The fundamental index is not focused on dividends. By the time you account for the other factors involved, the dividends would be lower than a value index. Using the US Value as a comparison tool, the value index has around the same dividend as the dividend yield index -- which is a more pure dividend play.

The fundamental index is not going to offer any tremendous diversification over the S&P 500 or total market.

As you and Norbert should know, I suggest the mid-cap value fund used in my Know-nothing portfolio, as it offers more diversification than Vanguard's large cap value, but if you are looking for dividends, the large cap value fund offers higher dividends. The smaller you go, the lower the dividends. The fundamental index is most likely going to offer lower dividends for this reason. In fact, I think DFA's large value index offers lower dividends than the Vanguard large value index, as does Vanguard's mid-cap value index.

Dividend focusing is an entirely different animal than fundamental focusing.

Chin

The argument is not about the advantages or disadvantages of value, small, dividends, etc. The argument is simply about the use of the term index. Fundamental index funds, high dividend yield index funds and so on are not index funds.

“It is not indexing,” insists Mr. Bogle. “It is a form of asset allocation, or active management strategy. It is being oversold as something it is not.” The case Mr. Bogle and his allies make is that, as he puts it, “the market return is the market return.” In other words, only cap-weighted indexes can mirror the market because market capitalization is what defines the market.

But fundamentally weighted indexes? They may well turn out to be a good idea, and become part of your portfolio. They may make you money in the long run. But they ain’t index funds, and they shouldn’t be viewed as a replacement for index funds.

Who is promoting the idea that these new funds are index funds? Only those who developed the idea. Why do they do it. Frankly, because it is a brilliant marketing idea. Hats off to Rob Arnott, the smart guy behind fundamental index funds. Also the smart guy who uses true index funds for his family's invsetments. 

 

Paul 

 

 

[quote user="norbertc"]

wonder why the Vanguard Value Index fund has performed so poorly.  Look HERE.  It has scarcely outperformed the S&P 500 fund.

Maybe it would be worthwhile to look at the idea of a fundamental index more carefully? 

Plus, I'm not convinced that the current bear market is over. 

[/quote]

 

So Growth had a better 2007 than Value.  SP500 is more growth leaning than a true blend.  Spread your chart from 200 days to 1100 days (3 yrs) and you'll see what VIVAX did to the S & P 500.

Fundamental index isn't an index--that is Bogle/Malkiel's argument.  It's active management using a strict formula for valuation.  It might be a great formula--we'll all know in 15 years.  

But it's not an index. 

To Chin...I was talking about INTERNATIONAL MARKETS,  not USA.  I cited an EXTRA reason for dividend tilt, as you had asked.

R48

[quote user="retired at 48"]

To Chin...I was talking about INTERNATIONAL MARKETS,  not USA.  I cited an EXTRA reason for dividend tilt, as you had asked.

R48

[/quote]

Hi R48,

You have lost me. I didn't ask about dividends before you mentioned them. I replied to your mention of dividends, and referred back to what we were talking about, the fundamental strategy, explaining it was not a dividend strategy.

I did go on to show the dividend funds Vanguard dividend funds do not offer much higher, and even less dividends than the value index fund. The High Dividend Yield Fund, their highest, only offers 3.2% compared to 3.03% for the value fund. The reason for using US comparisons was because I do not have access to the dividend payouts of the international value index to compare to a dividend focused strategy.

I finished this off by stating a dividend focused strategy and a fundamental focused strategy are not the same. I had to assume since we were talking about a fundamental focused strategy, maybe you offered a reason for investing in a dividend focus strategy because it followed the conversation we were having in some manner.

The fundamental focused strategy does include dividends, but is not a dividend focused strategy other than just considering them as one of the metrics. The point I tried to get across is the fundamental strategy, which they are calling an index, does not offer any higher dividends than Vanguard's large value index fund, and most likely less.

Is there some kind of international fundamental index that offers higher dividends than the international value index fund?

I don't understand why you would reply to me in this manner. Are you thinking of another conversation?

Chin

"I wonder why the Vanguard Value Index fund has performed so poorly.  Look HERE.  It has scarcely outperformed the S&P 500 fund."

We must be careful when using "price" charts to compare funds and returns.  This is because "price charts" do not reflect "total return" which includes dividends.

Perfcharts only show "price" and can be  misleading. 

com/charts/performance/perf.html?VIVAX,vfinx

Best wishes.
Taylor

Hi Chin; you stated:

"Why would anyone want a fundamental index over a value index? "

I presumed you were responding to Petrocelli's posting, which is about (the article's words) fundamental indexing, Wisdom Tree and International indices.  Wisdom Trees int'l indexing is based on dividend payers.  Thus it is the subject of this post.  If you define fundamental indexing on other parameters, then OK, but it is not the articles focus.

Thus when you asked why would one select fundamental vs cap weighted, I gave a reason why I selected Wisdom Tree, consistent with the postings theme.  I reiterate, the advantage of a dividend focus with international stocks (which gets around transparency issues)  may be best proven in a severe bear market or economic downturn.  Dividend payers may have the highest survival rate (fewest bankruptcies) and thus perform better.  I acknowledge Wisdom Tree makes up its own index, so the benchmark is a little elusive.  But I like this concept for international investing...and it gets very close to a full value tilt anyway.  So little harm, and we shall see.

R48

[quote user="retired at 48"]Hi Chin; you stated:

"Why would anyone want a fundamental index over a value index? "

I presumed you were responding to Petrocelli's posting, which is about (the article's words) fundamental indexing, Wisdom Tree and International indices.  Wisdom Trees int'l indexing is based on dividend payers.  Thus it is the subject of this post.  If you define fundamental indexing on other parameters, then OK, but it is not the articles focus.

Thus when you asked why would one select fundamental vs cap weighted, I gave a reason why I selected Wisdom Tree, consistent with the postings theme.  I reiterate, the advantage of a dividend focus with international stocks (which gets around transparency issues)  may be best proven in a severe bear market or economic downturn.  Dividend payers may have the highest survival rate (fewest bankruptcies) and thus perform better.  I acknowledge Wisdom Tree makes up its own index, so the benchmark is a little elusive.  But I like this concept for international investing...and it gets very close to a full value tilt anyway.  So little harm, and we shall see.

[/quote]

Hi R48,

I reread the article, and see where you would pick up on the idea a dividend strategy was fundamental indexing. It says;

"(Wisdom Tree, which markets more than three dozen fundamentally weighted exchange traded funds, uses a much simpler formula: its international E.T.F.'s use dividends, and most of its domestic index funds are earnings-based.)"

As you said, Wisdom Tree makes up its own indexes.

I guess technically Wisdom Tree's dividend-based indexes could be called a fundamental index, as a dividend is a more fundamental measure of weighing an index. I guess under this definition, Vanguards dividend funds could be called fundamental index funds, huh? ;o),

Fundamental indexes are generally thought of as weighed by sales, cash flows, book value and gross dividends, not just dividends. I don't know for sure, but assume when they speak of gross dividends, they include net share buybacks; pretty much the dividends accounted for, including the dividend increases per the reduction of shares from the net share buybacks.

The FTSE site is down at the moment, but maybe by the time you get to this it may be back up;

http://www.ftse.com/Indices/FTSE_RAFI_Index_Series/2006Downloads/FTSE_RAFI_Indexrules.pdf

If not, you can check the SWAB site here;

http://www.schwab.com/public/schwab/research_strategies/mutual_funds/funds/fundamental_index_funds

You can watch all the way through, or over to the right, in a little brownish box it offers "Read about the index and funds."

http://www.schwab.com/public/file?cmsid=P-1895971&refid=P-2287074&refpid=P-1798900

FWIW, I have no problem with, and in fact like dividend based funds. As a side note, some friends of mine and I studied individual small cap businesses many moons back and decided small cap businesses that paid dividends offered better, more secure returns. I imagine this could be extended to international small caps as well; hence my reasoning for using WisdomTree Europe SmallCap Dividend (DFE) in the ETFs I offered in the Asset Allocation thread to satisfy your suggestion of mentioning the ETFs.

You do remember that don't you?

http://socialize.morningstar.com/NewSocialize/forums/post/2513793.aspx

Recon that means I am a fan of fundamental indexing? ;o).

They started lookin real suspicious at him
He jumped up and said "Now just wait a minute Jim!
You know he's lying I been living here all of my life!"

"I'm a faithful follower of Brother John Birch
And I belong to the Antioch Baptist Church.
And I aint even got fundamentals; you can call home and ask my wife!"

Chin

 

To Chin...very good ending to the above post!  Looks like we meet on common ground.  Good.  See ya...I'll be repositioning north to Saratoga shortly, home of horse racing, ballet, polo and other sundry sports of southern gentlemen.

retired at 48

FYI: Regards,

Ted

 

SPY (500 Market-Cap.)
YTD=-(1.95)%
1yr= -(4.07)%
3yr= 8.88%
5yr=10.48%

RSP (Rydex Equal Weight S&P 500)
YTD=0.37
1yr=-(6.65)%
3yr=9.83%
5yr=13.10%

VFINX (Vanguuard S&P 500 Index Fund)
YTD=-(2.19)%
1yr=-(4.07)%
3yr=8.86%
5yr=10.46%

Isn't their basic premise that the large institutional investors who effectively set stock prices are paying too much for certain stocks based on their fundamentals? If so, would you still expect such mispricing to continue now that Arnott et al have shown the light or will this become another backtested strategy that then stops working? 

Another Rick 

Petro,

Thanks for the tip on the article.  Essentially, it reminded me of Rick Ferri's latest book: "The ETF Book."  Rick devotes a number of chapters on the development of market indexes and custom indexes using Index Strategy Boxes and differing index security selections and weightings.  He leaves the impression that many of the benchmark indexes are for the profit of the company creating them and used by fund/investment companies to make them look the best and most profitable compared to their competition.  This would appear to be a confounding factor in the argument over which is best.

ButWait  

 

[quote user="retired at 48"]

To Chin...very good ending to the above post!  Looks like we meet on common ground.  Good.  See ya...I'll be repositioning north to Saratoga shortly, home of horse racing, ballet, polo and other sundry sports of southern gentlemen.

[/quote]

Hi R48,

We may not always come to common ground, and that if fine. As I have offered earlier, one of my favorite thoughts, "Our delusions are more important to our happiness than reality."

I'm sure taken by itself, this statement sounds condescending, but is not in that manner in which I offer, but only food for thought.

My delusions are going to appear as much reality to me, as anyone else's delusions are going to appear reality to them. It is only through these discussions we can recognize our realities as delusions or reality, and of course, reality is only temporary. Even Einstein never gave up on some of his delusions, even though he recognized them for what they were, or at least he appeared to recognize them as what he called his ‘predetermined prejudices."

Thanks for your time and honest thoughts.

Chin

[quote user="rpike"]

Isn't their basic premise that the large institutional investors who effectively set stock prices are paying too much for certain stocks based on their fundamentals? If so, would you still expect such mispricing to continue now that Arnott et al have shown the light or will this become another backtested strategy that then stops working? 

[/quote]

Hi Rick,

I don't know this is necessarily true. As long as the size and value premium exist, the returns for the fundamental indexes will be higher. If it creates more effective diversification, it can also offer alpha.

All I question is the extent of this small/value premium and diversification. If what Travis Morion offered sometime back holds true, there is no higher probable risks to holding value stocks over a blend index such as the S&P 500. Per what he offered, if you looked at the draw down charts from Ibbotson, the actual tops and bottoms of the bulls/bears, not per annum data, value offered no higher risk than the S&P 500 benchmark. Even if this does not hold true, you have to look back to 1929 to define a higher value risk.

It is possible Fama/French large value such as with DFA or Rydex, or Vanguard's mid value may offer as good, if not better holding than a fundamental weighted index.

More than just an EMH based question on this, we have to ask how much we can depend on historic data period. Looking at the historic data itself, returns and correlations vary according to the period you look at.

If we thought we could go with historic data, what some call data mining, the retiree could go with 50/50 small value/commodities and depend on drawing 7% from their retirements. I think most in their right minds would not place that much confidence on this strategy. I don't see why they would place any more on a fundamental weighed index.

I think what this fundamental index is pointed to is for those who still believe in EMH, trying to find a way to improve on total markets. If they believe in EMH to the point of not value tilting, maybe fundamental indexing is a way to sway them in a more rhetorical way.

If 80 years worth of data offers only theory, I would imagine this could be looked at as only theory as well.

Who knows?

Chin