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September 11, 2006

Bogle And Malkiel Fight Back

Filed under: Investing — indexfundfan @ 3:20 pm

The following are excerpts from the article Bogle And Malkiel Fight Back:

When WisdomTree Investments launched its first 20 dividend-weighted exchange-traded funds (ETFs) in June, CEO Jonathan Steinberg didn’t hold back. Calling market-cap weighted indexes “flawed,” Steinberg said that his funds “had the potential to change the way investors think about indexing and investing.”

Weighting stocks by dividend, Steinberg said, as opposed to market capitalization, was simply “a better way to index.”

Writing on the op-ed pages of the Wall Street Journal, John Bogle and Burton Malkiel issued a fiercely worded bromide against “fundamental indexing,” calling it little more than a fad made possible by the tremendous outperformance of value stocks in the wake of the Internet bubble. Fundamental indexing’s large-scale outperformance, they suggest, is sure to be dashed … perhaps soon … against the rocky shores of reversion-to-the-mean.

“[W]e need to be cautious before accepting any “new paradigm” that implicitly suggests that the “old paradigm”— reflected in more than $3 trillion of capitalization-weighted index investment funds—is in error,” they wrote.

Costs Matter

Bogle and Malkiel start by pointing out the central, tautological truth of capitalization-weighted indexes: Investors as a whole must earn the same return provided by a capitalization-weighted index.

“We can not live in Garrison Keillor’s Lake Wobegon, where all the children are above average,” they write. “For every investor who outperforms the market, there must be another investor who underperforms.”

In fact, the universe of investors in aggregate must under-perform the benchmarks because you must deduct the fees and taxes that come with investing in the market. And that, say Bogle and Malkiel, is where fundamental indexes start to suffer.

The pair note that the expense ratios for publicly available fundamental index funds range from 0.49 percent to 1.14 percent. Although the WisdomTree ETFs cost significantly less than that, even their low fees (some as low as 28 basis points) are still significantly higher than traditional index strategies. The FTSE/RAFI U.S. 1000 PowerShare comes in at 60 bps.

Moreover, the pair notes, fundamental indexes will tend to experience higher turnover than cap-weighted indexe s , thanks to weighting adjustments mandated by changes in the fundamental factors. In cap-weighted indexes (at least, in total market cap-weighted indexes), those adjustments are made automatically with no cost to investors tracking the index.

Interestingly, the core backtested data published by WisdomTree, Arnott and others do not reflect the impact of fees or taxes.

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


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