Indexfundfan\’s blog (new URL is Indextown.com)

August 7, 2006

The next wave of index investing (?)

Filed under: Investing — indexfundfan @ 1:19 pm

Prof. Jeremy Siegel, who is a Director of, and a Senior Strategy Adviser to, WisdomTree Investments, Inc., a company that develops fundamentally-weighted dividend indexes and products, argues in the article The Next Wave of Index Investing that while “capitalization-weighted indexes have been a great way to invest (in the past), increasing evidence suggests that capitalization-weighted indexes may not be the best way to index an investor’s portfolio”.

Siegel thinks that a growing body of evidence suggests that fundamentally-weighted indexes may offer investors an attractive alternative to traditional cap-weighted indexes.

His arguments against the retort by capitalization-weighed supporters are reproduced below:

Supporters of the traditional capitalization-weighted indexes have criticized the fundamentally-weighted approach. Most notably, John Bogle and Burton Malkiel recently claimed that the five-year period from 2000 to 2005 is responsible for a large part of the difference between the backtested performance of dividend-weighted indexes and comparable cap-weighted indexes. But the performance of these fundamentally-weighted indexes over the last five years simply helped make up for the underperformance of such indexes during the tech boom of the previous five years, when dividend-weighted indexes significantly underperformed capitalization-weighted indexes.

To take out the last five years distorts the data. Using the same logic would allow you to say that tech stocks have a good track record over the past 40 years if we ignore the data since 2000 when tech stocks crashed. By underweighting the speculative sectors of the market compared to their market-cap weighted peers, dividend-weighted indexes did not experience the roller coaster ride that capitalization-weighted indexes suffered during this time period.

Supporters of market-cap weighted indexes have also questioned whether fundamentally-weighted indexes would, like their cap-weighted brethren, exhibit relatively low turnover when compared to more actively managed portfolios. While this may be a criticism of some fundamentally-weighted indexes, I do not believe this criticism is valid with respect to the category as a whole. There is no theoretical reason why properly constructed fundamentally-weighted indexes could not have nearly the same relatively low turnover rates, particularly if such indexes are reconstituted only once a year like many cap-weighted indexes.

Note: Some familiar “capitalization-weighted indexes” include the S&P 500, Wilshire total market, Russell 2000 etc. Example of “fundamentally-weighted indexes” include for example the Dow Jones Select Dividend Index (DVY) and many of the ETFs introduced by WisdomTree.

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5 Comments »

  1. Hi shlow,
    what do you think about these ETFs. personally i think they are tax inefficient for singaporeans. the div distribution will kill the returns in the long run.

    regards

    Comment by dividendinvesting — August 8, 2006 @ 6:07 pm

  2. btw i think u can change the link to my blog. i have moved to http://www.investmentmoats.com

    thanks and regards.

    Comment by dividendinvesting — August 8, 2006 @ 6:09 pm

  3. An index is a benchmark of measurement. Cap weighted stocks indexes measure the value of a basket of stocks. Equal weighted indexes measure the average price movement of those stocks. What do fundamentally-weighted portfolio measure? Nothing.

    In addition, an index has low turnover. Fundamentally-weighted funds have high turnover.

    The fact is fundamentally-weighted portfolios are not indexes. They are quantitative active management strategies that are called an index for marketing reasons. That make them “spindexes” not indexes. It is all about sales spin.

    Comment by Rick Ferri — August 21, 2006 @ 3:45 am

  4. It is not like I will make any change to my investment plan based on Siegel’s arguments. You are right, Siegel’s ETFs will have higher turnovers, and are also more expensive than tradtional ETFs.

    Comment by indexfundfan — August 21, 2006 @ 12:55 pm

  5. […] [Note : See post The next wave of indexing investing which discusses “fundamental indexing”.] […]

    Pingback by Bogle And Malkiel Fight Back « Indexfundfan’s blog — September 11, 2006 @ 3:20 pm


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