[in] the Financial Analysts Journal... letters [section] the magazine published in its March/April issue... André Perold, a finance professor at Harvard Business School, had written an article in a previous issue criticizing a new kind of financial product called fundamentally weighted indexes, which have been devised in large part by a man named Robert D. Arnott. Mr. Arnott is the chairman of Research Affiliates, a six-year-old company that markets and licenses such funds — and he’s also the former editor of The Financial Analysts Journal. “André Perold’s article in the November/December 2007 issue entitled ‘Fundamentally Flawed Indexing’ might have been better titled, ‘A Fundamentally Flawed Critique,’ ” steamed Mr. Arnott...
Mr. Perold quickly shot back (“This characterization is completely inaccurate.”), as did several other participants in the debate...
At its core, the fight is about whether fundamentally weighted indexes — which, unlike traditional index funds, don’t rely on market capitalization to “weight” a stock in an index — are superior to old-fashioned index funds, which allow investors to invest in such broad market indexes as the Standard & Poor’s 500 or the Russell 2000...
The real point of contention, however — and the reason this matters to investors — is that Mr. Arnott and Mr. Siegel make it sound as if their new indexing strategy is so far superior to traditional indexing that investors should abandon the latter for the former... “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.”... According to Mr. Bogle, Mr. Arnott and the Wisdom Tree folks are trying to do what all active managers do: beat the market. And sometimes they will, and sometimes they won’t. But they are not going to match the market because their funds are not, ultimately, trying to replicate the market the way a cap-weighted index fund does...
The argument for indexing is that the average investor will receive the average return. Divide investors into four groups: (i) passive investors, (ii) active investors who know more than the average active investor, (iii) active investors who know less than the average active investor but think they know more, and (iv) active investors who know less than the average active investor and think they know less.
Group (i) should index: they will receive the average return on average--and indexing is the way to do this with the least risk. Group (iv) should index as well: if they don't index, they are the fools in the market--and they know enough to know that they are the fools.
Group (ii) profit from their knowledge, inasmuch as group (iii) and those of (iv) who don't act on their knowledge of their own ignorance are their lawful prey--but everybody who thinks that he or she is in group (ii) should ponder hard whether he or she is in fact in group (iii) instead.
"Fundamental indexing" is a form of (ii): those who engage in it are active investors, and their informational edge--the thing they know that the average active investor doesn't--is that there are enough noise traders of group (iii) out there in the market that book or earnings or other fundamental weighting factors provide an easy way to take on the role of the house in the casino that is the stock market.
This is, I think, true -- until there comes a day when there are enough investors following fundamental-indexation strategies that they become part of the least-informed half of active investors.
This article has 6 comments:
- Brian Shriver
- 13 Comments
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May 22 10:37 AM- NO DooDahs
- 185 Comments
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May 22 12:22 PMNot 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.
- mydoghatescats
- 9 Comments
May 22 02:38 PM- Geoff Considine
- 303 Comments
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May 23 01:46 PMTo 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
- mydoghatescats
- 9 Comments
May 24 05:46 PMIf 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.
- stumpydog
- 1 Comment
May 30 11:01 AM