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Scott Burns' Articles -- Recent and Archived

The Looming Battle: Fundamental vs. Traditional Indexing

arrow.gifIdeas have consequences.

If the idea works, those who bet on it make money. If it doesn't work, they lose money.

Today, the biggest idea battle in investments is between "fundamental indexing" and "market-capitalization indexing."

In traditional market-capitalization indexing you replicate an existing market exactly as it exists. Then you trust that you'll earn the return of that asset class, less tiny fees.

The best-known example of this is the Vanguard 500 index fund. The object of mockery when it was launched in 1976, it has done better than 70 percent of its managed large-cap blend competitors over the last 10- and 15-year periods. Along the way it has accumulated nearly $70 billion in assets. It thrived while multitudes of managed competitors were quietly buried.

The first recent challenge to traditional indexing came from Robert Arnott and his firm, Research Affiliates. Launched last December, the Powershares RAFI 1000 index (ticker: PRF) returned 14.65 percent for the first 10 months of this year, while the Vanguard 500 index returned "only" 11.90 percent.

During the summer, Wisdom Tree began a full-scale assault on market-capitalization indexing. It launched an arsenal of 20 "fundamental index" exchange-traded funds that cover the major markets of the entire world. "In contrast to cap-weighted indexing, fundamentally weighted indexes anchor the initial weights of individual stocks to some metric of fundamental value," the Wisdom Tree Web site says.

While the RAFI 1000 index is based on a basket of fundamental measures, the Wisdom Tree funds are keyed to a single fundamental -- dividends. They do this because "cash dividends provide an objective measure of a company's value and profitability -- one that cannot be manipulated by accounting schemes."

Basically, the indexes give us the hope of being paid more now while we hope to be paid still more in capital gains later. Back-testing them from 1980 through 2005 showed that the idea appears to work. Wisdom Tree Dividend index returned 14.71 percent annually, while the Wilshire 5000 index returned 12.87 percent. Similarly, the Wisdom Tree Small Cap Dividend index returned a whopping 17.15 percent, while the Russell 2000 index returned 12.14 percent.

Over the 10 years ending March 31, 2006, Wisdom Tree's Pacific ex-Japan High-Yielding Equity index returned a stunning 16.66 percent, while the MSCI Pacific Rim ex-Japan value index returned only 6.91 percent and the MSCI Pacific Rim ex-Japan index returned 5.65 percent.

Does this mean we should pile in?

I don't think so. When you index stocks with primary attention to dividends, you create a portfolio that is likely to be concentrated in a few industries. You also create a portfolio that is highly sensitive to interest rates.

Purchase the Wisdom Tree Small Cap Dividend index ETF, for instance, and you'll be purchasing an index that is a whopping 60 percent financial stocks. That's almost three times the weighting of financial stocks in the Russell 2000 index.

Purchase the Wisdom Tree Large Cap Dividend fund and 30 percent of your money will be committed to financial stocks. (In contrast, only 22 percent of the Standard & Poor's 500 index or the Russell 1000 index is in financial stocks.)

Why should we worry about this?

History.

Electric utility stocks were the darlings of the early 1960s. They were praised for their high yields and their healthy growth rates. Those who invested with enthusiasm suffered for nearly 20 years while interest rates rose and price-to-earnings multiples collapsed.

The same fate may await a portfolio dominated by financial stocks.

Decades of research show that there are only two consistent sources of higher returns in the stock market: small-cap stocks and "value" stocks -- those with low price-to-book-value ratios. Those are the areas for fundamental indexing to pursue.

Skeptics should consider the track record of Dimensional Funds Advisors, the original fundamental indexer. Its Small Cap Value fund, a rules-based fundamental index, has returned 15.60 percent annually over the last 10 years. That puts it at the top of the small-cap value fund heap.

Similarly, its Large Cap Value fund has returned 12.08 percent a year over the last 10 years, placing it in the top 4 percent of large-cap value funds.

Why haven't you heard of them?

Simple: The minimum investment in either fund is $2 million, unless you work through a financial adviser.

ON THE WEB

The Wisdom Tree The Powershares Dimensional Fund Advisors

Published Nov 11 2006, 06:00 PM by scottb
Filed under:

Comments

 

ABModerator03 said:

i'm confused about etf's being lower expense than index investing. etf's reqire a broker, so if you buy once, sell in 2 parts, the expenses, even for the lowest online broker, are higher than index expenses. please clarify. thank you.

From Scott Burns:

Yes, ETF's require a brokerage transaction. That means their total cost will be equal to what you pay in brokerage commissions plus their annual expense ratio. That doesn't mean, however, that ETF's are dead meat.

You just have to do the math and figure out if your account is large enough that commission costs will be an insignificant expense. You can get a quick estimate by using my online calculator:

and the related column about ETF portfolio expenses:

If you'd like a rule of thumb, I think anyone with $50,000 of assets and a portfolio with 3 to 6 asset holdings won't be harmed by ETF commission costs.

This is particularly true for readers who are in a Fidelity 401(k) plan that has a self-directed brokerage option. These investors can combine FIDOs very low cost Spartan index funds for core investments in the U.S.

Total Stock Market and the EAFE index for equities. Then, they can use ETFs to fill out their holdings in, say, a REIT ETF, and both small and large cap value index ETFs.  
November 13, 2006 5:12 PM
 

ABModerator03 said:

Dear Mr. Burns,

You frequently state, with back-up evidence, that an index fund such as the Vanguard 500 Index Fund beats more than 70% of managed funds over a given time period.

I assume that the mix changes from year-to year of those 30% of the managed funds that beat index funds.

But are there any data to show that change? I have searched your archives but can't find an article on that.

Thank you,

Ted

From Scott Burns:

Research support for indexing has been repeated in different contexts since the late 1960s. The move to indexing began when it was discovered that institutional investors that operated at lower expenses than retail mutual funds failed to beat their benchmark index about 70 percent of the time. Since then, repeated studies have shown retail mutual funds also fail.

More important, while a literal handful of funds have successful (index beating) long term records, many do exactly as you suggest--- they beat the index for a year or two, but quickly fade. Jack Bogle has done a number of these studies, showing that last years' leaders are poor selections for the future. So have a variety of academics.

One of the things that many investors don't understand is that the same volatility that may put a fund at the top of the heap one year is the volatility that will bury it in another year. Because of this, the fund that remains in the top 50 percent of its peer group year after year after year will eventually rise to a higher long term position. That's why so few managed funds with long records have beaten the index.

According to the Morningstar mutual fund database, for instance, the Vanguard 500 Index fund has been in the top 25 percent in 6 of 29 annual periods, the second quartile in 14 of 29 periods, the third quartile in 6 of 29 periods, and the bottom quartile in only 4 of 29 periods. Three of those bottom quartile periods were in the first years of operation for the fund--- 1977, 1978, and 1979. Very few managed funds are in the top 50 percent 69 percent of the time.  
November 13, 2006 6:28 PM
 

ABModerator03 said:

The idea of fundamental indexing is very interesting to me. I see some advantages, because the weighting formula has the potential of selecting a better distribution of stocks. But there are also drawbacks, as you discussed. For one, the turnover will be higher. In a market cap weighted index, it pretty much adjusts for itself. In a fundamental index, the fund has to buy and sell a lot more to maintain the desired allocation. This drives up transaction costs and taxes. These particular funds also produce a lot more dividends, which will have tax consequences in a taxable account.

I started to wonder if the difference comes from asset allocation which could be duplicated using conventional index funds.

The major difference is that RAFI 1000 has a significant value tilt. It also has a slight small-cap tilt. If I were a betting man, I would wager that most of the difference in return can be accounted for by the heavy emphasis on value stocks. RAFI 1000 has a median P/E of 14.3 which is much more in line with Vanguard Value Index than Vanguard Total Market Index. While RAFI returned 14.7% and Vanguard S&P 500 Index returned "only" 11.9%, Vanguard Value Index returned 16.9%.

Perhaps the next step in your investigation of these funds should be to determine how they perform compared to a portfolio of conventional index funds which match the style distribution of RAFI.

From Scott Burns:

You can find a good discussion of this in Bill Bernstein's Journal of the Efficient Frontier, www.efficientfrontier.com, May 2006 edition. As you suggest, most of the out-performance can be explained by the fact that the RAFI 1000 has a greater weight of small cap stocks than the S&P 500 and a higher value stock weighting.

It isn't yet clear whether the RAFI 1000 ETF will actually have a higher turnover rate than the S&P 500 rate, which is 7 percent. According to the Morningstar database, both the iShares Russell 1000 index ETF and the iShares Russell 1000 Value ETF also have turnover rates of 7 percent. My bet is that the RAFI 1000 rate will be very close---so the fund won't have materially higher expenses due to portfolio turnover.

Portfolio turnover expenses are an issue with some index funds. The Vanguard Small Cap Index fund, for instance, has a turnover rate of 18 percent, their Small Cap Value Index fund has a turnover rate of 28 percent, and their Small Cap Growth Index fund has a turnover rate of 39 percent. Those rates are multiples of the turnover for large cap portfolios.

Even so, index funds as a group have vastly lower turnover rates than typical managed funds. The Morningstar database indicates the average managed small cap fund has a turnover rate of 84 percent.  
November 15, 2006 2:25 PM
 

ABModerator03 said:

I agree with your arguments against the Wisdom Tree funds, but does the same arguments apply to Arnott's PowerShares RAFI 1000 ETF? Does his index tilt as heavily toward certain industries? Would you still recommend against his ETF?

Thanks.

From Scott Burns:

I thought the RAFI 1000 would be a good fund, and a good idea, ever since I read Arnott's first research on fundamental indexes. While we could have a long discussion of where the superior returns come from--- see Bill Bernstein's analysis on www.efficientfrontier.com --- the pragmatic reality is that using multiple fundamental measures results in a more diversified portfolio.

Here's a comparison of four ETFs, pulled from the Morningstar database, all figures expressed as a percentage relative to the S&P 500
Sector Russell 1000 Russell 1000 Value RAFI 1000 WisdomTree LargeCapDIV
Information Economy 0.98 0.64 0.79 0.64
Software 0.97

 0.14 0.69 0.46
Hardware 0.96 0.25 0.56 0.33
Media 1.09

 1.09 1.06 0.46
Telecom 0.97 1.74 1.26 1.83
Service Economy 1.02 1.04 0.99 1.01
Healthcare 1.03 0.60 0.72 0.91
Consumer Services 1.03 0.44 1.12 0.55
Business Services 1.17 0.40 0.93 0.40
Financial Services 0.99 1.64 1.12 1.34
Manufacturing Economy 0.98

 1.16 1.14 1.21
Consumer Goods 0.95

 0.97 1.25 1.45
Industrial Mat. 0.96 0.84 1.00 1.09
Energy 0.99

 1.52 0.95 0.95
Utilities 1.16 1.87 1.97 1.74
Source: Morningstar
As you can see, the RAFI 1000 varies less from the S&P 500 allocations in most categories than the Russell 1000 Value ETF or the WisdomTree Large Cap Dividend ETF. It under weights technology (the information economy) less than either the R1000 Value or the WisdomTree ETF.

If it delivers the 200 basis points of additional return indicated by backtesting, it will easily justify the additional cost over traditional cap weighted index costs.
November 17, 2006 10:30 AM
 

ABModerator03 said:

I wonder about the effect that large index funds can have on smaller companies. For instance, could a smaller company change its financials (such as increasing dividends) to get bought by a large index fund? The potential bump-up in stock price might be used as a pump-and-dump scheme by the company or some large shareholders. Would this be legal?

From Scott Burns:

The reason this won't happen is that pump-and-dumpers would have to use real money (dividends) to get an uncertain result, increased demand for their stock. Also, whatever the popularity of ETFs and index mutual funds, they remain a relatively small source of market demand for equities.  
November 17, 2006 9:21 PM
 

ABModerator03 said:

Scott

I have read with interest your articles on RAFI funds.

What about the Rydex Equal Weighted Funds? They don't look specifically at dividends, but equal weight monthly.

You also mentioned that you would put an RAFI fund in your taxable personal account. Is that right? Doesn't the "rebalancing" create unnecessary taxes?

Ron

  

From Scott Burns:

Rebalancing doesn't create unnecessary taxes if the investment is in a qualified account. Rebalancing is about the only way you can control/adjust the level of risk in your portfolio. In the big picture, risk management trumps tax minimization.

I don't mean to sound cavalier about taxes, I'm not. We just have to know when they are being paid to pursue a greater cause--- risk control.
November 28, 2006 11:59 AM
 

ABModerator03 said:

[...] Looming Battle: Fundamental vs. Traditional Indexing [...]
December 29, 2006 10:29 AM
 

Financial Investment said:

On Wall Street, if a little of something is good, then a lot of it must be magnificent. How else to explain

August 17, 2007 3:31 PM
 

Financial Investment said:

On Wall Street, if a little of something is good, then a lot of it must be magnificent. How else to explain

August 17, 2007 3:38 PM
 

Financial Investment said:

Allow me to introduce the yellow brick road of investing. Follow this road and you will be a happy investor

September 28, 2007 1:41 PM

About scottb

Scott Burns has covered the changing world of personal finance and investments for nearly 40 years. Today, he ranks as one of the five most widely read personal finance writers in the country. Scott began his career as a newspaper columnist at the Boston Herald in 1977 where he was also the financial editor. Nationally syndicated in 1981 and now distributed by Universal Press, the column appears in newspapers from Boston to Seattle. In 1985 he joined the staff of the Dallas Morning News where his column quickly became one of the most widely read features in the paper. He left the Dallas Morning News in 2006 to become one of the founders of AssetBuilder and its Chief Investment Strategist. Burns is a graduate of Massachusetts Institute of Technology (1962). He has written four books, including "The Coming Generational Storm" (MIT Press, 2004) coauthored with economist Laurence J. Kotlikoff. His fourth book, also coauthored with Kotlikoff, will be published this spring by Simon & Schuster. "Spend Til' the End" uses consumption smoothing to demonstrate the errors of conventional financial planning. His business experience includes working as a staffer for a major consulting company and service as a director and audit chairman of a NASDAQ listed manufacturing company. He and his wife divide their time between Dallas and Santa Fe, New Mexico.
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