In short, the study worked out like this: during periods where value outperformed, the fundamentally weighted indexes beat market-cap benchmarks; during periods where growth outperformed, they trailed. The fundamental indexes may not be just value indexes, but they are certainly correlated with value-based outperformance.
BOSTON — Fundamental indexing — touted as a “better mousetrap” alternative to capital-weighted market indexes — won’t necessarily catch more mice, according to Harvard professor Andre Perold.
In a draft paper, “Fundamentally Flawed Indexing,” Mr. Perold, the George Gund Professor of Finance and Banking at Harvard Business School in Boston, argues that a pillar of the fundamental-indexing sales pitch — that cap-weighted indexes deliver “inferior” returns by overweighting overvalued companies and underweighting undervalued companies — doesn’t stand up to scrutiny.
Marshaling the same models and two-stock portfolios used by proponents to make their case, his paper concludes that the idea “that capitalization weighting imposes an intrinsic drag on performance is false.”
And I guess I’m scratching my head when I think, why would you use the number of employees to figure out how you should weight a stock?
The sheer effect of weighting by dividend yield would certainly give you a value bias. Using some of these other factors also produces a bit of a value and a small-cap bias.
My greatest concern is I don’t think investors do realize what they’re getting. A lot of times, the way these are marketed is they beat the S&P 500.
And then finally, we create our own indexes for our own internal research, and we’ve compared the returns of those various indexes, our large-cap growth, our small-cap value, and so on, compared the returns over the last 40 years of our indexes versus these fundamental indexes.
We look at financial theory, and modern portfolio theory would not predict that small-cap value or any segment of the market would outperform. So you start wondering why, and I guess if you look at it in the broadest sense, some segment of the market had to outperform. If there’s a race, somebody’s going to win it.
And it so happened to be that the winner was small-cap value. Now, is there a reason for that? Quite honestly, it’s tough to point to a reason. Some of the researchers like Fama and French, who really got a lot of notoriety over their work identifying small-cap value, they propose that maybe you’re being compensated for taking on additional risk.
We’ve had a difficult time trying to identify the fact that there is additional risk. So it boils down to the fact that we don’t have a great deal of confidence saying that just because small-cap value has outperformed in the past means it will in the future. And you know, investors should just be aware that they’re taking that bet, that the past will repeat itself. We think it’s much more prudent to invest in the entire U.S. marketplace rather than a segment of it.
I mean, basically you’re getting beta; you’re getting the market rate of return, or a segment of the market.
The interesting thing about a cap-weighted index is, it’s self-rebalancing. So you’re not going to incur transaction costs and potentially realize capital gains by continually rebalancing a fund. These fundamental indexes, since they are not cap-weighted, they need to be constantly rebalanced. And you have costs associated with that, and potentially capital gains that need to be paid.
How many of those are in the S&P 500 (or TSX 60 or EAFE)? What percentage of their respective indexes do such companies represent?parvus wrote:why would you use a speculative take on a no-earner company with momentum gamblers behind it to construct your index?
No! No! No! So?And there's a problem in investing in companies that actually earn money and show it by paying the owners? Or should we all have been subprime borrowers and lenders? Are we talking about stocks that reflect real economic growth, or just the ones that the punters favour?
Again, so? No stock picker, not even Warren Buffett, picks winners much more often than losers. Why should a fundamental index creator be any different?Do they know what they're getting with the S&P 500? After seven years of a drawdown, guess what, the tech and telecomm stocks that drove the market bubble and the S&P 500 are still deadweights in arrears, return-wise.
Nope. (Not that I concede the S&P500 is a growth index...) The only guarantee with market-cap weighting is that you get whatever your chosen index has to offer in the future (minus the MER.) What guarantees does fundamental indexing offer (apart from substantially higher MERs, transactional costs and more taxes than cap-weighting)?there's no guarantee that large-cap growth will perform in the future either.
It's not as an index. The broader the index the less significant the differences. Compare the correlation between Russell 3000 vs. DJ/Wilshire 5000 vs. MSCI Total Market. However, the licensing costs to the fund sponsor may differ significantly. The index reconstitution rules may also minimize the frictional costs of implementation. Those sorts of differences are significant to be sure, but they're not, er, fundamentally significant for most investors.And BTW, which total market index? Why is MSCI better than Wilshire?
Depends on the index, how broad it is and how it's rebalanced. Are you arguing that the same isn't also true of fundamental indexes?Well, if you're talking S&P 500, how often is it rebalanced/restructured? And the Russell indices. How about a sampled index? How often are realized capital gains from rebalancing used to offset management fees?
How would the answer to that question differ for fundamental indexes?Would those capital gains have been more efficiently deployed in the shareholder's hands?
parvus wrote:why would you use a speculative take on a no-earner company with momentum gamblers behind it to construct your index?
How many of those are in the S&P 500 (or TSX 60 or EAFE)? What percentage of their respective indexes do such companies represent?
Quote:And there's a problem in investing in companies that actually earn money and show it by paying the owners? Or should we all have been subprime borrowers and lenders? Are we talking about stocks that reflect real economic growth, or just the ones that the punters favour?
No! No! No! So?
Standard & Poor's has been criticized by some Wall Street pros for allowing tech shares to become such a big part of the index. But the firm says it had no choice. As investors swarmed into tech issues, they boosted their importance in the market, obligating S&P to add more to the index, said Howard Silverblatt, senior analyst at the firm.
"The S&P 500 emulates the market, good, bad or indifferent," he said.
It has taken over two years for most investors to realize that the robust markets of recent years were an expensive illusion. Dishonest accounting of earnings, a manipulated new issues market, and aggressive stock buybacks helped create the impression that stock price increases were inevitable and unlimited. Throughout this entire crazy period one thing that remained relatively constant was the cash dividends paid out by companies. While reported earnings boomed for the 500 companies in the S&P 500 Index during 1999 and 2000, the level of dividends paid out by the 500 companies remained the same as in 1997. Dividends are often a reliable indicator of the sustainable, real earnings stream at a company. It is interesting that after rising sharply in 1998 and 1999, the S&P 500 index is now back to its 1997 level.
The profitability criteria are four quarters of positive net income on an operating basis. Sometimes, Standard & Poor’s will include a company that would be profitable except for a loss due to a merger or acquisition. A recent example of this is JDS Uniphase (JDSU), which was added in July 2000.
Finally, for the S&P 500 there are no capitalization restrictions. The guiding principle for inclusion in the S&P 500 is leading companies in leading US industries. Generally, companies are over $4 billion, although Standard & Poor’s sometimes adds companies below this range. For example, Visteon (VC) — a spin-off from Ford Motor Company — was added to the S&P 500 in June 2000 despite its market cap of only $1.6 billion because its sales were similar to those of S&P 500 companies and the company is considered to be a leader in its industry. In reality, most companies added to the S&P 500 are much bigger than $4 billion. For example, technology company JDS Uniphase entered the S&P 500 with a market cap of over $90 billion. Indeed, as of August 31, 2000, the average market cap for the S&P 500 was $26.7 billion, compared to $2.4 billion for the S&P MidCap 400 and $668 million for the S&P SmallCap 600.
parvus wrote:Even though I found the interview fascinating — thanks for linking it, BTW — I thought Gus was a tad more one-sided than he should have been, e.g.,
sweedy wrote:I also noticed that many financial gurus in FWF chose not to comment about fundamental indexing. For example, pitz, what do you think?
NormR wrote:sweedy wrote:I also noticed that many financial gurus in FWF chose not to comment about fundamental indexing. For example, pitz, what do you think?
Ok, so I'm not pitz.
Fundamental Indexing (TM) is cleverly packaged value investing. As such, you might also consider other value offerings such a DFA's funds, value ETFs, the O'Shaughnessy funds, even active value managers, etc.
sweedy wrote:So I agree that fundmental indexing is value investing repackaged.
DenisD wrote:sweedy wrote:So I agree that fundmental indexing is value investing repackaged.
I prefer to think of it as value investing with a growth component. So, it should outperform value investing when growth outperforms, like recently. It might underperform value investing during value manias. IIRC, a back test showed that it outperformed at least one value index.
Obviously, the main disadvantage is higher fees.
NormR wrote:The 'growth' bit is just marketing spin. Asness (in the now invisible paper) destroyed the argument. It's just a different way of value investing and not all that different.
Fund Name Tick 2006 YTD 1M 3M 12M
iSh Rus 1000 Growth Index IWF 8.7 6.3 -1.4 0.3 18.7
iSh Rus 1000 Index IWB 14.9 3.4 -3.2 -2.0 15.3
iSh Rus 1000 Value Index IWD 21.7 0.2 -5.0 -4.4 11.6
iSh Rus 2000 Growth Index IWO 13.1 3.7 -5.1 -1.5 16.3
iSh Rus 2000 Index IWM 17.8 -0.8 -7.0 -4.3 11.9
iSh Rus 2000 Value Index IWN 22.8 -5.6 -8.6 -7.7 6.2
PowerShares US 1000 PRF 18.0 2.7 -4.5 -2.5 14.5
PowerShares US 1500 PRFZ ~ 1.5 -5.9 -3.3 ~
NormR wrote:Here's the Asness paper
In addition, at the right investment management fee and given more information about the details, I am a potential fan of fundamentally constructed portfolios.
The approach is a clean, simple way to describe how to construct an active, value based portfolio.
Both efficient and inefficient market explanations for the success of value predict higher returns for Fundamental Indexes, so evidence that they have higher returns adds literally nothing to this ongoing discussion.
NormR wrote:Fundamental Indexing (TM) is cleverly packaged value investing. As such, you might also consider other value offerings such a DFA's funds, value ETFs, the O'Shaughnessy funds, even active value managers, etc.
DenisD wrote:NormR wrote:Fundamental Indexing (TM) is cleverly packaged value investing. As such, you might also consider other value offerings such a DFA's funds, value ETFs, the O'Shaughnessy funds, even active value managers, etc.
I'm curious, Norm. O'Shaughnessy did a 40 plus year back test of his algorithms. Without the back test, would you still include the O'Shaughnessy funds in that sentence?
NormR wrote:O'Shaughnessy value is basically a high dividend yield fund.
DenisD wrote:NormR wrote:O'Shaughnessy value is basically a high dividend yield fund.
I assume you mean US Value. It's not so high yield any more since he started adding buybacks to yield a few years ago. Some of the new funds are partially high yield. But they use more than one strategy.
DenisD wrote:I guess we'll have to agree to disagree on the importance of back testing.
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