Articles

Fundamental Indexing Smackdown
By Rob Arnott, Gus Sauter, Jeremy Siegel

Related ETFs: ROB / DON

Page 1 of 4

Over the past few years, one of the biggest topics of debate in the indexing industry has involved how to weight companies in an investable index. Critics of the traditional approach have said that "capitalization weighting," by definition, overweights overvalued stocks and underweights undervalued stocks, leading to a persistent drag on returns. Fans of the traditional system dismiss those criticisms by pointing out, essentially, that there is no free lunch. The debate has raged at conferences, on the sales floor and in the op-ed pages of The Wall Street Journal.

In an effort to settle things, the Journal of Indexes convened a debate with three of the leading figures in the space. On the side of alternatively weighted indexes, we had two supporters:

Rob Arnott, chairman of Research Affiliates and co-creator of the RAFI Fundamental Indexes.
Jeremy Siegel, Russell E. Palmer Professor of Finance, author of Stocks for the Long Run and senior strategic advisor for WisdomTree Investments, a provider of dividend- and earnings-based indexes and exchange-traded funds (ETFs).

Arnott and Siegel were joined by Gus Sauter, chief investment officer for Vanguard and one of the most well-known proponents of capitalization-weighted indexing.

Jim Wiandt, editor of the Journal of Indexes, moderated the debate.

Jim Wiandt (Wiandt):The issue of alternatively weighted indexes has been a hot topic for the past two years, so to kick off this debate, I'd like to ask Gus Sauter a basic question: What's your thinking on the criticism that's been leveled at cap-weighted indexes?

Gus Sauter (Sauter): I guess the criticism is that capweighting is not weighting by an optimal factor. I think the unfortunate thing is that we don't know what the optimal factor is. We can't observe intrinsic value, so we don't know exactly how a stock should be weighted.

But I would also point out that there is a very simple reason why cap-weighted indexing is a very effective way to gain exposure to a market, and that's the well-known argument that outperformance is a zero-sum game; in aggregate, investors own the marketplace, so therefore before cost they are only going to get the market rate of return. They won't get anything more or anything less in aggregate. Of course, some investors may outperform, but others have to underperform to offset that outperformance. And once we introduce costs into the equation, we know in aggregate investors are going to get less than the market rate of return, and that means that investors who marginally outperformed before costs become underperformers after cost.

So then the question is, what is the market? The market by definition is cap-weighted, as it is the collection of all of our holdings. And, therefore, cap weighting, which is the definition of the market, will outperform a majority of investors. It doesn't rule out that active management may be able to add value, but it does point out that active management is a very, very difficult game. Anything other than a cap-weighted index is taking active bets against the market, and I would just ask the rhetorical question: Is it really so easy for active management to be able to add value?

Wiandt: That's a nice segue to Rob. So, Rob, what do you say to some of the critics of the RAFI fundamentally weighted indexes who say that they are simply a repacking of existing ideas that have been on the market, like value investing, whether those are active or index-based value strategies?

Rob Arnott (Arnott): The folks who characterize Fundamental Index-based concepts of constructing different indexes as just the repackaging of value are partly right and partly wrong. Fundamental Index weights companies in accordance to their footprint in the broad economy, whether that's based on a company's sales, its profits, its book value, its dividends, its total assets, its number of employees … you name it. And in so doing, it breaks the link between over- and undervaluation and the weight in the portfolio. That's its principle strength.

But by breaking the link with price and market cap, you wind up with a portfolio that mirrors the economy. The stock market is cap-weighted. The cap-weighted market does not mirror the economy: It mirrors what the market thinks the economy will look like in the future and is prepared to prepay for today. That is to say, most of your money is in growth companies, where the market is expecting better-than-average growth, profitability and so forth, and the market's prepaying for that growth before it happens. That's just fine. So what you wind up with in cap weighting is a completely unbiased index measured relative to the market, but an index with a growth bias relative to the economy.

Fundamental Index is completely unbiased relative to the economy, but has a value tilt relative to the cap-weighted market. So those who say it's a value strategy are right; it does have a value tilt relative to the cap-weighted market. But because the market is constantly adjusting what it pays for growth relative to value, for popular sectors relative to unpopular sectors and so forth, Fundamental Index contratrades against wherever the market has its greatest excesses, and contra-trades back to a portfolio that mirrors the composition of the economy.

Is it a repackaging of value and of DFA [Dimensional Fund Advisors] ideas and Fama-French [research from Eugene Fama and Kenneth French]? No, it's a separate idea; it's an idea of constructing and weighting an index based on the economic footprint that a company has, as opposed to weighting companies in accordance with what the market thinks their future will look like. I think it's a very sensible, very simple idea. I think the proof of the pudding is that over the life of the Russell 1000 Value index, going back 28 years, Fundamental Index has had roughly half as much of a value tilt as the Russell index—but has provided twice as much [incremental return]. Over that 28-year-old span, it outperforms the cap-weighted indexes by 2.4 percent per year compounded, while value leaves out all the growth segments of the market and adds only half as much incremental return.

Wiandt: With that, I'll turn to Jeremy Siegel. The short question is, why dividends? The extended version is, what do the WisdomTree indexes bring investors that cap-weighted indexes and some of the other alternative weighted indexes like the RAFIs don't?