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 When WisdomTree Investments launched its first 20 dividend-weighted exchange-traded funds (ETFs) in June, CEO Jonathan Steinberg didn't hold back. Calling market-cap weighted indexes "flawed," Steinberg said that his funds "had the potential to change the way investors think about indexing and investing."
Weighting stocks by dividend, Steinberg said, as opposed to market capitalization, was simply "a better way to index."
Steinberg wasn't the first to attack market-cap-weighted indexes. Far from it: Nouveaux indexers had been openly attacking the indexing establishment for the better part of two years, ever since the March/April 2005 publication of Rob Arnott's paper, "Fundamental Indexation," in the Financial Analysts Journal. (And indeed, long before that! Arnott's paper just re-opened an ongoing debate).
Arnott's paper argued that cap-weighted indexes systematically overweight overvalued companies and underweight undervalued companies. He proposed an alternative weighting methodology based on four fundamental factors-book value, dividends, cash flow and revenues-that he claimed would lead to higher returns.
Other index designers, including the folks at Steinberg's WisdomTree Investments, have since proposed using dividends or other fundamental factors to weight stocks. But no matter what metric is used, the goal is the same: To design an index that will outperform traditional cap-weighted benchmarks.
For the most part, traditional indexers haven't felt the need to fight back. After all, index funds have trillions of dollars in assets and a library of supporting academic research that would take a lifetime to consider. But the combination of the WisdomTree launch and a strongly worded editorial by Jeremy Siegel in the Wall Street Journal ("The Noisy Market Hypothesis," June 14, 2006) appears to have provoked the traditionalists. On June 27, 2006, they struck back.
Writing on the op-ed pages of the Wall Street Journal, John Bogle and Burton Malkiel issued a fiercely worded bromide against "fundamental indexing," calling it little more than a fad made possible by the tremendous outperformance of value stocks in the wake of the Internet bubble. Fundamental indexing's large-scale outperformance, they suggest, is sure to be dashed ... perhaps soon ... against the rocky shores of reversion-to-the-mean.
"[W]e need to be cautious before accepting any "new paradigm" that implicitly suggests that the "old paradigm"- reflected in more than $3 trillion of capitalization-weighted index investment funds-is in error," they wrote.
Their argument in favor of cap-weighted indexing comes in two parts, and will be familiar to readers of this publication (see Steven Schoenfeld's survey of alternative index weighting methodologies in the May/June issue of the Journal of Indexes). Nonetheless, in light of the continuing debate surrounding this issue, it bears closer examination.
Costs Matter
Bogle and Malkiel start by pointing out the central, tautological truth of capitalization-weighted indexes: Investors as a whole must earn the same return provided by a capitalization-weighted index.
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