The Pros and Cons of Fundamental Investing

I get a lot of questions about index funds from over the years because readers know that I am a huge advocate of index funds. Over the long run, they provide low-cost superior returns compared to other mutual funds.

What I haven’t written about before, however, is fundamental indexing. This new type of indexing has triggered the academic equivalent of trash talking by some of the brightest people in the industry.

There has been a flood of new mutual funds and exchange-traded funds that are being powered by fundamentally weighted indexes. Fundamental index enthusiasts believe that using the predominant cap-weighted indexes, such as the Standard & Poor’s 500, will generate lower returns. Why? Because they say the traditional indexes such as the S&P 500 and MSCI EAFE, which is the popular foreign benchmark, must make the most room for the companies with the greatest stock market values. This traditional way of putting corporations into indexes, the fundamentalists insist, has lead to a bias towards expensive growth stock and a lamentable practice of the index gatekeepers buying stocks high and selling low.

The new indexers tweak the benchmarks differently by avoiding cap-weighted measures and instead relying upon such things as a company’s free cash flow, book equity value, total sales and gross dividends. Here’s what quant expert Robert Arnott, the chairman of Research Affiliates in Pasadena, CA, who is patenting his fundamental indexing approach, told me: “It’s not that we know what the correct weight is, but we know capital-weighted indexes will automatically overweight the overvalued and underweight the undervalued.”

The skeptics, and there are plenty, counter that fundamental indexing, is simply cashing in on the phenomenally long run that value stocks have enjoyed the last few years. The critics insist that it’s not fair to compare a traditional index fund tied to the Standard & Poor’s 500 with a fundamental index fund because the composition is biased towards value stocks than the underlying index would suggest.

Fran Kinniry, a principal at Vanguard told me that one of these new fundamental index fund that ostensibly invested in major blue chip companies would actually resemble the Vanguard Mid-Cap Value Index Fund if anybody looked under the hood. “We would never go out into the marketplace nor would our legitimate competitors like Fidelity, T Rowe Price or Barclays and say our mid-cap value fund beating your S&P 500 fund,” Kinniry insisted.

In an interview with the Journal of Indexes, Eugene Fama and Kenneth French, two academic titans, who conducted seminal research on the market’s value and small-cap premium, sided with Vanguard. Fundamental indexing boils down to “just value versus growth,” French argued. “It’s nothing more than that.” In an article in Institutional Investor last year, Clifford Asness, a major financial luminary, “Fundamental indexing is really just a rebalancing of the most debated, and most promising, side bet out there — value investing — and as such maybe be an attractive investment product. But Fundamental Investing is certainly nothing even remotely new under the investing sun. Instead, Fundamental Indexing is just a catchy term for a long-established discipline.”

In addition to Rob Arnott’s firm, the other principal source of overseas and domestic fundamental indexing is WisdomTree Investments, which offers lots of exchange traded funds. WisdomTree’s academic firepower is Jeremy Siegel, the highly respected finance professor at the Wharton School. One of WisdomTree’s approaches is based on company dividends and the other on earnings. Arnott’s fundamental stock strategies are being used by Charles Schwab, which released three fundamental mutual funds in April, including Schwab Fundamental International Large Company Index Fund, and PowerShares, which now offers a variety of fundamental funds.

Obviously, the fundamental index funds don’t have long track records, but what’s impressed many investors is the backtesting. Nomura Securities, in a study published by the Japan Security Analysts Journal in 2005, for instance, looked at the 23 countries in major developed world stock and concluded that fundamental indexing beat the traditional approach in each of the countries since 1988. The contest wasn’t even close with an average disparity of more than 260 basis points or 2.6 percentage points. The back testing for domestic stocks was equally impressive. Fundamental Index Back Testing

If you peer inside a global fundamental index and a cap-weighted one, you’ll see many of the same companies, but their prominence is different. When Nomura Securities did its study, for instance, Microsoft was ranked third largest with a 1.28% weighting in the traditional index in 2005, while it dropped to 33rd place in the fundamental version. Nippon Telegraph & Telephone occupied the 9th spot in the fundamental index, but it didn’t place in the top 30 in the cap-weighted version.

These new fundamental index funds aren’t the only passive or quasi- passive approach that deviate from traditional indexing. Dimensional Fund Advisors in Santa Monica, CA, which has offered funds for many years that are based on Fama and French’s research, has successfully tweaked many of their international funds to capture small-cap and value premiums. DFA Emerging Markets Value (DFEVX), for instance, recently had a 70.13% one-year return and an annualized 48.17% return during the past three years, which Morningstar says has placed it in the top 1% of its peers. DFA International Value (DFIVX) and the firm’s other large-cap overseas value funds are also clustered at the very top of the performance heap. To obtain these and other Dimensional Fund Advisor funds, you must go through certain fee-only advisors.

I suspect that Asness and the other critics are right. Fundemental indexing might be a different way of being rewarded for leaning a portfolio toward value. Of course, over time, you should be able to enjoy that value premium by investing in regular index funds that purposely try to capture it, such as those offered by Dimensional Fund Advisors or through Vanguard, iShares or other index and ETF providers. Vanguard’s value funds include Small-Cap Value Index Fund (VISVX) and Vanguard Value Fund (VIVAX), which invests in large-cap stocks. iShares offerings include Standard & Poor’s SmallCap 600 Value Index (IJS) and Standard & Poor’s 500 Value Index (IVE).