By: Investor Solutions, Inc.
Index fund investing can bare a strong resemblance to a long term marriage. You know you are in the right place, with the right person and you know that the marriage is good for you, but after twenty or thirty years together you start to wonder if there is something just a little more exciting out there for you. Temptations can lead you down the wrong path, potentially disrupting this great relationship you already have. In the world of indexing, this tempting seductress is called Fundamental IndexingTM, whose radical departure from traditional indexing methods begs the question, “why bother?”
Index funds have been around for three decades now, when pioneers like John Bogle and the geniuses at Dimensional Fund Advisors launched their indexing revolution. Yeah, index funds are boring–there’s no doubt about that. Frankly, there is very little sex appeal to the dull, drab approach of a passive investment strategy, despite the fact that it’s a far superior solution for investors. But, it works! So, if you are looking for ways to spice up your portfolio, fundamental indexingTM is not the cure-all.
Traditional index funds like the funds available through Vanguard and structured index funds like those at DFA are based on market cap weightings. Most of the major indexes (like the S&P 500) are based on the member companies’ size (stock price X number of outstanding shares). If you believe that market prices are fair and reflect all available information, then by default you are an efficient market hypothesis (EMH) devotee. Cap weighted indexes are based on the EMH. In complete contrast to the EMH, fundamental indexers believe the market mis-prices securities and that mis-pricing is what drives the investment returns. Did I miss something? What part of that sounds like an index fund?
Advocates of fundamental indexingTM suggest that capitalization-weighted indexes overweight stocks that are trading above fair value and underweight stocks that are trading below true fair value. They claim that these errors create a negative alpha, or drag on the return. So, in order to overcome this “drag”, fundamental indexersTM contend that portfolios that are indexed by some fundamental factor (i.e. an index based on dividend payments, company’s sales, cash flows, revenues, earnings, etc.) could significantly outperform a traditional cap-weighted index of market values. For example, Research Affiliates n partnership with index provider FTSE Group has created 24 fundamental indices. The RAFI 1000 is an index constructed on the basis of four equally weighted measures of company size including gross revenue, equity book value, cash flow and five year trailing dividends. How has the performance compared to traditional indexes? Too soon to tell, while in theory the RAFI index demonstrates excess performance over the S&P 500, it’s based only on historical back testing. There are no live funds to make reasonable comparisons with. And when you factor in costs and taxes, the benefit may quickly evaporate. Essentially, the fundamental indexTM funds are just an expensive way to get a value tilt in your portfolio.
Bill Sharpe, one of the originators of the Capital Asset Pricing Model, thinks this is a form of active management. It is generally understood that an index should reflect the total investible assets available within a specific asset class or cross section of the global market. The problem with the fundamental indexing approach is that a fundamental index fund will likely end up with weightings that are quite different that that of the market as a whole. For example, the stock market includes billions of dollars worth of companies that may pay little or no dividends to shareholders. Investors employing a dividend-based fundamental indexing strategy would have little or no representation in those thousands of stocks.
Additionally, fundamental indexesTM charge higher management fees, conduct frequent rebalancing, exhibit higher turnover and are generally less tax efficient than traditional index fund, all of which lead to higher expenses for the shareholder. Traditional index funds keep costs down by bypassing the need for market analysts, stock pickers and minimizing portfolio trading.
In summary, if you are bored of your plain vanilla portfolios of broad based indexes and are enticed by the allure of something fresh; remember that what you want is already at your feet. If you want to inject some sizzle into your indexed portfolio, consider accepting some of the other dimensions of equity risk instead. Investors can engineer portfolios that deliver above global market index returns by designing a strategic portfolio tilt. Specifically, exposing your portfolio to the risk factors embedded in small cap stocks and value oriented stocks can lead to higher expected returns over time, as compared to a fundamental indexTM.