FTSE RAFI Canadian Index ETF to launch 22Feb06

[adrian2]

I am quite skeptical of the practical value of the RAFI, for pretty much the same reasons as Yogi and Bernstein (op. cit.).

Re-reading some old pdf's I have saved, I came across this commentary from TIFF (March 1999). Check out the graphs on page 2 (US stocks tripling in value in the previous 5 years, vs. EAFE up a "mere" 50% and Emerging Markets down 30%). Do I need to remind you how they performed subsequently?

Even more interesting, and relevant to this thread, are the graphs on page 3, depicting the relative small vs. large, and equal-weight vs. cap-weight. After 5 years of cummulative 30% underperformance of an equal weight product, such as RAFI, compared to the "invincible" S&P500, would you have had the intestinal fortitude to keep the course and hold on to RAFI? Don't forget increased taxes and transaction costs, as well as the possibility of decreased investors demand which could potentially lead to the fund being discontinued at the worst possible moment.

To end this trip down memory lane, on page 5:
US 10 year bond yield: 5.2%
US 10 year inflation adjusted bond yield: 3.9%
Market's inflation forecast 1999-2009: 1.3%

[Bylo Selhi]

Bogle and Malkiel, um, weighed in to defend cap-weighted indexing in an op-ed piece in the WSJ. A fragment is available on Bogle's eBlog:

While we have witnessed many “new paradigms” over the years, none have persisted. The “concept” stocks of the Go-Go years in the 1960s came, and went. So did the “Nifty Fifty” era that soon followed. The “January Effect” of small-cap superiority came, and went. Option-income funds and “Government Plus” funds came, and went. High-tech stocks and “new economy” funds came as well, and the survivors remain far below their peaks. Intelligent investors should approach with extreme caution any claim that a “new paradigm” is here to stay. That’s not the way financial markets work.

Can someone with access to the WSJ post the rest of the piece?

Added: More is revealed here:

Turn on a Paradigm

As index funds gain an increasing share of the portfolios of mutual funds, academics and practitioners are hotly debating how these portfolios should be composed.

Eugene Fama and Kenneth French have suggested that higher returns can be generated by indexed portfolios of stocks with small capitalizations and low price-to-book value ratios. Robert Arnott has argued that a better method for indexing is to weight the stocks in the index, not by their total capitalization, but rather by certain "fundamental" factors such as sales, earnings or book values. Jeremy Siegel has proposed that the "fundamental factor" should be the dividends that companies pay. These analysts have all argued that fundamentally weighted indexes represent the "new paradigm" for index fund investing.

There is no doubt that fundamentally weighted indexes have outpeformed capitalization-weighted indexes during the past six years. But we need to be cautious before accepting any "new paradigm."

During the three-plus decades that passively managed funds have been available, they have provided for their investors returns substantially superior to the returns achieved by actively managed equity funds.

Let us put to rest the canard that the remarkable success of traditional market weighted indexing rests on the notion that markets must be efficient. Even if our stock markets were inefficient, capitalization-weighted indexing would still be--must be--an optimal investment strategy.

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

Because the average actively managed fund must underperform the capitalization weighted market as a whole by the amount of intermediation costs that are deducted from the gross return achieved, active investing must be, and is, a loser's game.

The portfolios of market-weighted index funds are automatically adjusted for changes in the market caps of their portfolio holdings, and they require no turnover. But fundamentally wieghted indexes gain no such advantage.

Fundamental weighting also fails to provide the tax efficiency of market weighting. Taxes are a crucially important financial consideratin because the premature realization of capital gains wil substantially reduce net returns.

Fundamental weighting will tend to produce portfolios that give more wieght to companies that are smaller in size and have value characterstics. Most of the long-term excess return attributed to fundamentally weihted portfolios was achieved between 2000 and 2005 alone, one of the best periods in history for the relative returns of dividend-paying stocks, value stocks, and small-cap stocks. The premiums offered by such stocks may well now have been arbitraged away.

We are impressed by the inexorable tendency for reversion to the mean in security returns.

Since the late 1960s, value funds have generally outperformed growth funds. But since 1977, indeed since 1987, there is little to choose betwee the two. Indeed, for the first 30 years, growth funds rather consistently trumped value funds.

Never think you know more than the markets. Nobody does.

While we have witnessed many new paradigms over the years, none has persisted. The "concept" stocks of the Go-Go years in the 1960s came, and went. So did the "Nifty Fifty" era that soon followed. The "January Effect" of small cap superiority came, and went. Option-income funds and "Government Plus" funds came, and went. High-tech stocks and "new economy" funds came as well, and the survivors remain far below their peaks.

Investors should approach with extreme caution any claim that a "new Paradigm" is here to stay. That's not the way financial markets work.

Taylor says the above are excerpts. Is there more?

[George$]

Can someone with access to the WSJ post the rest of the piece?

For our friend Bylo (with blue emphasis re chart)

Turn on a Paradigm?
By John C. Bogle and Burton G. Malkiel
27 June 2006
The Wall Street Journal


As index funds gain an increasing share of the portfolios of mutual funds, institutional equity and bond funds, academics and practitioners are hotly debating how these portfolios should be composed. Capitalization-weighted indexing, until now the dominant approach, has come under fire for overweighting portfolios with (temporarily) overvalued stocks and underweighting them with undervalued ones.

Eugene Fama and Kenneth French have suggested that higher returns can be generated by indexed portfolios of stocks with small capitalizations and low price-to-book-value ratios. Robert Arnott has argued that a better method for indexing is to weight the stocks in the index not by their total capitalization, but rather by certain "fundamental" factors such as sales, earnings or book values. Jeremy Siegel has proposed that the "fundamental factor" should be the dividends that companies pay. These analysts have all argued that fundamentally weighted indexes represent the "new paradigm" for index-fund investing.

Are they correct? We think not. There is no doubt that fundamentally weighted indexes have outperformed capitalization-weighted indexes during the past six years, which witnessed the collapse of the "new economy" bubble and partial recovery. But we 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. During the three-plus decades that such passively managed funds have been available, they have provided for their investors returns substantially superior to the returns achieved by actively managed equity funds. We need to understand why capitalization-weighted indexes make sense -- even if market prices are "noisy" and can fluctuate above or below the values they would have in a perfectly efficient market.

First let us put to rest the canard that the remarkable success of traditional market-weighted indexing rests on the notion that markets must be efficient. Even if our stock markets were inefficient, capitalization-weighted indexing would still be -- must be -- an optimal investment strategy. All the stocks in the market must be held by someone. Thus, investors as a whole must earn the market return when that return is measured by a capitalization-weighted total stock market index. We can not live in Garrison Keillor's Lake Wobegon, where all the children are above average. For every investor who outperforms the market, there must be another investor who underperforms. Beating the market, in principle, must be a zero-sum game.

But only before the deduction of investment management costs. In practice, investors as a group will fail to earn the market return after these costs, and as a group, they will fall far short of the low-expense index funds. For the typical actively managed equity mutual fund, annual operating expense ratios are well over 100 basis points (one percentage point). Add in the hidden costs of portfolio turnover and sales loads, where applicable, and effective annual costs are undoubtedly considerably higher, perhaps as much as 200 to 250 basis points. In total, simply because the average actively managed fund must underperform the capitalization-weighted market as a whole by the amount of financial intermediation costs that are deducted from the gross return achieved, active investing must be, and is, a loser's game.

Purveyors of fundamentally weighted indexes also tend to charge management fees well above the typical index fund. While index funds also incur expenses, they are available at costs below 10 basis points. The expense ratios of publicly available fundamental index funds range from an average of 0.49% (plus brokerage commissions) to 1.14% (plus a 3.75% sales load), plus an undisclosed amount of portfolio turnover costs.

The portfolios of market-weighted index funds are automatically adjusted for changes in the market caps of their portfolio holdings, and they require no turnover. But fundamentally weighted indexes gain no such advantage. Suppose, for example, we use a fundamental index based on dividends. If one company doubles its dividend, the portfolio manager then needs to buy enough of the stock (and sell enough of the other stocks) to double the weight of the stock in his fundamentally weighted portfolios. All fundamentally weighted indexes must incur turnover costs to align the weights of the portfolio with changing fundamental factors and changes in the market price of different securities.

Fundamental weighting also fails to provide the tax efficiency of market weighting. If a stock doubles in price and its fundamental weighting factor (be it dividends, book value or anything else) remains unchanged, the portfolio manager must sell enough of the stock to bring its weight back into balance. Thus, a fundamental index fund will tend to realize capital gains (and highly taxed short-term gains if adjustments are made frequently). Taxes are a crucially important financial consideration because the premature realization of capital gains will substantially reduce net returns.

One important characteristic of fundamental indexing needs to be emphasized, for it explains why such indexing can often appear to produce outperformance. Every method of fundamental indexing tends to overweight smaller capitalization stocks and so-called value stocks. Consider the rationale for fundamental indexing. If, during some speculative bubble, money pours into high-tech stocks, their weight in a cap-weighted index increases. Since their price rise generally exceeds any fundamental measures of value, such as dividends or book value, such stocks will tend to have increased cap weights versus fundamental weights.

Consequently, fundamental weighting will tend to produce portfolios that give more weight to companies that are smaller in size (capitalization) and that have "value" characteristics such as low prices relative to earnings, dividends, sales and book values. Fundamental indexing will tend to do well in periods when small-cap stocks and "value" stocks tend to outperform. Thus it is not surprising that most of the long-term excess return attributed to fundamentally weighted portfolios was achieved between 2000 and 2005 alone, one of the best periods in history for the relative returns of dividend-paying stocks, "value" stocks and small-cap stocks.

We concede that there is some evidence, based on numbers compiled by Ibbotson Associates, that long-run excess returns have been earned from dividend-paying, "value" and small-cap stocks -- albeit returns that are overstated by not taking into account management fees, operating expenses, turnover costs and taxes. But to the extent that investors are persuaded by these data, the premiums offered by such stocks may well now have been "arbitraged away" in the stock market, as price-earnings multiples have become extremely compressed.

We are impressed by the inexorable tendency for reversion to the mean in security returns. Consider the chart showing the difference between mutual funds with a "value" mandate and those with a "growth" mandate. Since the late 1960s, "value" funds have generally outperformed growth funds. But since 1977 -- indeed since 1937 -- there is little to choose between the two. Indeed, for the first 30 years, growth funds rather consistently trumped value funds. Never think you know more than the markets. Nobody does.

We never know when reversion to the mean will come to the various sectors of the stock market, but we do know that such changes in style invariably occur. Before we too easily accept that fundamental indexing -- relying on style tilts toward dividends, "value" and smallness -- is the "new paradigm," we need a longer sense of history, as well as an appreciation that capitalization-weighted indexing does not depend on efficient markets for its usefulness.

While we have witnessed many "new paradigms" over the years, none have persisted. The "concept" stocks of the Go-Go years in the 1960s came, and went. So did the "Nifty Fifty" era that soon followed. The "January Effect" of small-cap superiority came, and went. Option-income funds and "Government Plus" funds came, and went. High-tech stocks and "new economy" funds came as well, and the survivors remain far below their peaks. Intelligent investors should approach with extreme caution any claim that a "new paradigm" is here to stay. That's not the way financial markets work.

[Bylo Selhi]

For our friend Bylo

Merci. And in return... Two Investment Gurus Square Off on the Future of Indexing

Clearly, indexing has served investors well and is here to stay. But can it be made even better? Wharton finance professor Jeremy Siegel thinks so. The standard index, which gives more weight to stocks of bigger companies, should be replaced by "fundamental indexing" that assigns each stock a role based on factors like corporate sales or dividend payments, Siegel says. "Capitalization-weighted indices are no longer the best ones for investors. Fundamentally weighted indices will give you superior risk and return characteristics."

But many index-investing experts are unconvinced. "I don't believe in new paradigms," says John C. Bogle, founder of the Vanguard Group mutual fund company, which specializes in traditional index investing...

[parvus]

Adrian2 wrote:

After 5 years of cummulative 30% underperformance of an equal weight product, such as RAFI, compared to the "invincible" S&P500, would you have had the intestinal fortitude to keep the course and hold on to RAFI?

Yep. Even if Arnott is only tapping Fama-French factors, I would rather have that than the insidious glamour stocks. Mind you, I prefer classic TV (1950s -1960s). I know what to expect. That said, I don't currently own a TV.

But we've gone through this before. The S&P 500 isn't the total market; it's momentum-weighted; and U.S. stocks are still overvalued, compared to a 14 or 15x historical earnings average. I'm not a fan of Titanic investing: ride the launch and sink with it (until it meets the delisting criteria).

Bylo quoth:

There is no doubt that fundamentally weighted indexes have outperformed capitalization-weighted indexes during the past six years, which witnessed the collapse of the "new economy" bubble and partial recovery. But we 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. During the three-plus decades that such passively managed funds have been available, they have provided for their investors returns substantially superior to the returns achieved by actively managed equity funds. We need to understand why capitalization-weighted indexes make sense -- even if market prices are "noisy" and can fluctuate above or below the values they would have in a perfectly efficient market.

Now why might that be? Pension funds and 401(k)s throwing too much money at already oversized Putnam, Fidelity or Janus funds? Slavish devotion to beta plus tracking error? (And why do most U.S. investment gurus inhabiting the biz skules have their 401(k)s in T-bills — does anyone recall that LA Times article? Advice for the rest of us from within their ramparts? Gimme a break. )

Given the delinking Malkiel suggests of indexing and efficient markets, then what matters is cost, returns and manager mobility, oh and index-inclusion artifacts. Remember when there were five Canadian stocks on the S&P 500. Hmm. Some science.

Even if our stock markets were inefficient, capitalization-weighted indexing would still be -- must be -- an optimal investment strategy.

For large institutional investors, who find it hard to work big blocks, but then there's Liquidnet.

All the stocks in the market must be held by someone.

Yep, including the Pink Sheets. Wanna give that a try? In truth, the indexes include only the most liquid stocks, and broader market indexes inevitably involve sampling, unless you're DFA (cf. Vanguard). And sampling is active management.

As it is, the S&P 500, whose inclusion rules are far from unrandom, given the "representativeness" criterion, is, in fact actively managed as an economic benchmark — that feeds Fed rates and Conference Board leading indicators — not an investor-friendly one.

Beating the market, in principle, must be a zero-sum game.

Depends what market you're talking about. cf representativeness supra.

For the typical actively managed equity mutual fund, annual operating expense ratios are well over 100 basis points.

Maybe, maybe not. But anyway, I thought we were talking about "fundamental indexes" not mutual funds. So the cost is 40 more basis points. Is that worth foregoing a Nortel or an Enron?

The expense ratios of publicly available fundamental index funds range from an average of 0.49% (plus brokerage commissions) to 1.14% (plus a 3.75% sales load), plus an undisclosed amount of portfolio turnover costs.

And cap-weighted ETFS, swaps and futures are transaction-cost-free? No wonder Baudrillard described America as a simulacrum of DisneyWorld: the model is more real than the reality!

The portfolios of market-weighted index funds are automatically adjusted for changes in the market caps of their portfolio holdings, and they require no turnover.

Perhaps because of cross-trades that may now have to be subject to best-execution rules? Remember, there's underlying market activity here. Crosses are free, well, there may be soft-dollar costs. But you're essentially talking Wal-Mart. Someone is paying the cost. You just don't see who it is.

Suppose, for example, we use a fundamental index based on dividends. If one company doubles its dividend, the portfolio manager then needs to buy enough of the stock (and sell enough of the other stocks) to double the weight of the stock in his fundamentally weighted portfolios. All fundamentally weighted indexes must incur turnover costs to align the weights of the portfolio with changing fundamental factors and changes in the market price of different securities.

Suppose, for example, your media subsector just got hollowed out with the takeover of CHUM. And you, as a substantial unitholder, have to vote your proxies through BGI or State Street. Hmm. Or your company votes to become an income trust that has restrictions on U.S. ownership (cf. Critchley today on BCE's block trade). There's no turnover cost here?

Taxes are a crucially important financial consideration because the premature realization of capital gains will substantially reduce net returns.

Yet institutions are generally tax-exempt, and so wouldn't suffer on a fundamental-index basis. All index funds make occasional distributions, some on a regular basis.

Consequently, fundamental weighting will tend to produce portfolios that give more weight to companies that are smaller in size (capitalization) and that have "value" characteristics such as low prices relative to earnings, dividends, sales and book values. Fundamental indexing will tend to do well in periods when small-cap stocks and "value" stocks tend to outperform.

Yep. So what's your point? Do you buy a new car every year because it's hot? Do you change wives on the basis of market momentum? Have you ever run a business? Or do you stick with the tried and true, without getting overly excited? Or do you mean, at each moment in time, you have to be exactly matched to the fortunes of the market, as if it were an iPod?

We never know when reversion to the mean will come to the various sectors of the stock market, but we do know that such changes in style invariably occur.

Ya mean Amurricans may have to pay off the current-account deficit, but not just yet, not till the party's definitively over? And that growth is now undervalued, just because value hasn't reverted to the mean? Or that market-cap weighting philosophies must revert to the mean, and become common-sense, just because they once were? Ideas, like companies, do go way past th eman and become bankrupt. Indeed, one could argue that market-cap weighting is Fordism imposed on the financial-industrial complex. But consumer/investor behaviour does change, and with it, market-momentum effects.

But I find Malkiel's plaint quaint: "Ya know, just for memory's sake, I want to hold onto this glamour-weighted index because, you know, the momentum stocks of 1999 remind me of partying like 1999." But that's simply a wistful behavioural reverting to the mean (good) memories that occur on a randomly remembered past.

Okay, okay, give me a different unpacking of that article.

[Shakespeare]

[url=https://secure.globeadvisor.com/servlet/ArticleNews/story/gam/20060722/STMAIN22]Seeking sanity amid a market of ETF mania
ROB CARRICK finds that there are places to attain wisdom about which exchange-traded funds are right for your portfolio[/url]

What's the word on this new ETF? To find out, head to the Financial Webring Forum and its "Funds and ETFs" section. You'll find a lot of back and forth here on the FTSE RAFI fund, as well as on other topics, such as dividend ETFs (focusing on stocks with solid dividend yields) and ETFs that track commodity indexes.

Thanks, Rob.

[yielder]

Thanks, Rob.

Thank you, Rob.


Mike

[Bylo Selhi]

Will Arnott's Index Win the Marathon or Sprint?

The true test of whether Arnott's index beats cap-weighted indexes partially rests on the nature of investor behavior. One of Arnott's assumptions in creating the index is that companies with the highest market values have the majority of the investment community behind them. Often that groupthink overvalues stocks, as was the case in the late 1990s. In other words, Arnott's index bets that the herd is wrong most of the time, one of the central tenets of a school of thought called behavioral finance.

Success may breed mediocrity, though. If adopted by most stock investors, Arnott's index will itself become the consensus opinion of market leaders, and may be cursed over time to achieve only average returns. Then again, those adopting Arnott's approach may be wisely betting against the quirks of human nature, an often reliable wager in a jittery market.

[parvus]

bylo quoth:

Success may breed mediocrity, though. If adopted by most stock investors, Arnott's index will itself become the consensus opinion of market leaders.

Oh, I think we're some ways from that now. After all, this isn't a Y2K stampede, and the institutional investors with serious money are still trying to figure out how to match their evolving liabilities with expensive real return bonds.

In other words: so much money available, and so many constraints on its use. But I wouldn't rule out a regime shift five years hence, once investors get the notion of total returns thunked into their heads. By that time, I suspect BCE will be an income trust.

[Bylo Selhi]

Jeremy Siegel weighs in (and declares his excess baggage too)...

The Next Wave of Index Investing

On EMH:

Increasing evidence suggests that this hypothesis may not be the best explanation for changes in stock prices. The prices of securities are impacted by far more factors than those only related to valuation. For example, speculators, insiders, momentum traders, and those who must buy and sell because of tax or fiduciary reasons also impact the price of stocks even though their transactions are unrelated to the fundamental value of the underlying company. I believe the best way to characterize financial markets is to say that the true value of securities is often obscured by "noise," which are transactions that influence the price, but are unrelated to fundamental valuation. I call this way of characterizing how financial market prices are determined the "Noisy Market Hypothesis." A growing body of research supports this hypothesis.

Retort to "Retort by Capitalization-weighted Supporters"

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.

[parvus]

bylo wrote:

Jeremy Siegel weighs in (and declares his excess baggage too)...

I dunno, kind of hard to live off the proceeds of a stock that doesn't pay dividends, (unless the company returns the share certificates they bought back for furnace purposes, instead of financing employee options).

Siegel wrote:

Readers of this column know that I have always been fond of dividend-paying stocks. My research, published in my book The Future for Investors, has shown that on an historical basis, the bulk of the real return from stocks has come from dividends and that high dividend-yielding stocks have historically given higher returns to investors than low dividend-yielding stocks.

We can't be certain that this long-term trend will continue, but based on the historical results I believe it is natural to choose dividends as the metric by which to weight individual stocks in an index. (In the interest of full disclosure, I am a Director of, and a Senior Strategy Adviser to, WisdomTree Investments, Inc., a company that develops fundamentally-weighted dividend indexes and products. Some of the research on dividend-weighted indexes that I discuss is based upon my work for this company.)

And, stocks in the long run did pay dividends, until the go-go 1990s, when the S&P index committees got into ex post market-timing. So, if Malkiel et al. can caution, `we don't know, ex ante, which managers will beat the market,' the S&P'ers can say: 'we've got a solution: we'll give you our version of what worked in the past, or what would have worked in the past, if we'd been up to our chops.'

Actively managed market-cap weighted indexes aren't exactly an antidote to random walks (and all investable indexes are actively managed).
Or, to cite Siegel:

During the 1980s, increasing evidence revealed that certain stocks -- particularly "value stocks," or those that were smaller in size than the S&P 500 Index and/or had low prices relative to such fundamental variables as earnings -- outperformed capitalization-weighted indices.

Small stocks were riskier on average than larger stocks, but they had higher returns even accounting for this risk. Furthermore, it was very easy to form portfolios of small and value stocks, and the costs of holding portfolios of these favored stocks was low.

As a result of these findings, many advisors and academics began to "tilt" their portfolios toward small and value stocks. In fact, index providers such as Standard & Poor's and Russell soon concocted small stock and value stock indices to cater to investors interested in these stocks.
portfolio toward these favored sectors?

If I were Arnott, since, as discussed above, Malkiel and Bogle have thrown out the efficient markets hypothesis, and with it, CAPM, as justifications for indexing — all that remains, as George Bernard Shaw once suggested to an upper-class "lady," is negotiating the price — then the difference is between "disciplined indexing" and "opportunistic indexing."

[YogiBear]

Actively managed market-cap weighted indexes aren't exactly an antidote to random walks (and all investable indexes are actively managed). [emphasis added]

Not true, by any reasonable definition of "investable" and "actively"- the Dow Jones Wilshire 5000 Composite Index is eminently investable- has been by several funds succesfully (e.g., VTI in the past)- albeit with some fudging toward the smaller end of the cap range (which does not seem to affect tracking error to any great degree). The inclusion/ exclusion rules, as publicized at least, are about as mechanical as one could imagine. And best of all, since it is essentially total market, index turnover is minimal by any standard.

[parvus]

yogi wrote:

albeit with some fudging toward the smaller end of the cap range

Exactly my point. You can't after all be a little bit pregnant. It's one or the other.

That said, I don't mind "enhanced indexing." Yep, it's active. It would have spared the 1999 class of S&P500 indexers their what, seven-year drawdown, based on Blitzer and company's active "mechanical" decisions.

[adrian2]

That said, I don't mind "enhanced indexing." Yep, it's active. It would have spared the 1999 class of S&P500 indexers their what, seven-year drawdown, based on Blitzer and company's active "mechanical" decisions.

Maybe, maybe not. After all the criticism for the supposedly "active" S&P 500, it has done a pretty good job of tracking the "market". As did the "naive" arithmetic average of Dow 30.

Review my link upthread from Tue Jun 13, 2006 2:24 pm: in 1999 (start point of your comparison), an equal weight index would have underperformed by 30% in the previous 5 years. I'd say that the 1994 class of S&P500 indexers is probably still ahead. In other words, end date bias (or if you prefer, start date bias).

[YogiBear]

yogi wrote:

albeit with some fudging toward the smaller end of the cap range

Exactly my point.

Ah well, so you prefer to focus on doctrinal purity, or lack thereof, rather than results (the second part of my sentence that you did not quote): "which does not seem to affect tracking error to any great degree". Your choice. I look at minimal tracking error relative to an unmanaged investable index and see success.

That said, I don't mind "enhanced indexing." Yep, it's active. It would have spared the 1999 class of S&P500 indexers their what, seven-year drawdown, based on Blitzer and company's active "mechanical" decisions.

Take 5 minutes, go to Norbert's site and download his excellent spreadsheet on annual returns for various asset classes. The returns for your "actively managed" S&P 500 are in the column next to those for the total market, mechanical Wilshire 5000 index I referred to upthread. Torture the data a while, try to make them scream a bit. Amazing, isn't it? After 30 years (1975 to date), virtually the same average annual return. Virtually the same standard deviation. If that is active management, it is pretty darn good, matching the total market over 30 years! Or, is it that you want to find active management, no matter what?

[parvus]

Adrian wrote:

Review my link upthread from Tue Jun 13, 2006 2:24 pm: in 1999 (start point of your comparison), an equal weight index would have underperformed by 30% in the previous 5 years. I'd say that the 1994 class of S&P500 indexers is probably still ahead. In other words, end date bias (or if you prefer, start date bias).

upthread:

Even more interesting, and relevant to this thread, are the graphs on page 3, depicting the relative small vs. large, and equal-weight vs. cap-weight. After 5 years of cummulative 30% underperformance of an equal weight product, such as RAFI, compared to the "invincible" S&P500, would you have had the intestinal fortitude to keep the course and hold on to RAFI? Don't forget increased taxes and transaction costs, as well as the possibility of decreased investors demand which could potentially lead to the fund being discontinued at the worst possible moment.

bylo's quote:

Success may breed mediocrity, though. If adopted by most stock investors, Arnott's index will itself become the consensus opinion of market leaders.

I'm tempted to say QED: we know the mass market will not adopt Arnott's indexes, leaving lots of inefficient market opportunities for first adopters.

If you're a trader, you won't get the benefits of any indexing whatsoever. If you buy and hold, you're assuming growth and value cancel each other out (or did, until growth was found to depend on overstated earnings, and now it seems to depend on back-dated stock options); I do have the intestinal fortitude to stay with a value manager — but not any value manager: I want to see discipline. I can sustain years of underperformance, so long as I know what the manager is doing. But that's a long-term buy and hold.

No, I can't predict ex ante which value managers will outperform; but then again, despite his random walks, Malkiel kinda liked closed-end trusts, which of course take time and patience in order to realize their value. QED?

yogi wrote:

Not true, by any reasonable definition of "investable" and "actively"- the Dow Jones Wilshire 5000 Composite Index is eminently investable- has been by several funds succesfully (e.g., VTI in the past)- albeit with some fudging toward the smaller end of the cap range (which does not seem to affect tracking error to any great degree). The inclusion/ exclusion rules, as publicized at least, are about as mechanical as one could imagine. And best of all, since it is essentially total market, index turnover is minimal by any standard.

Interesting, don't you find, that Vanguard decided to shift its licence fees to another index provider? So which index provider are we supposed to trust? Anyway, I'd prefer to follow information/Sharpe ratios rather than tracking errors. More to the point, you seem to assume the U.S. is the market. At 48% of world market-capitalization, it's hard to miss; but remember, in 1989 Japan commanded the same market share, with the U.S. at about 35% IIRC. But I do agree with cheap total market coverage. Just not with S&P.

Take 5 minutes, go to Norbert's site and download his excellent spreadsheet on annual returns for various asset classes. The returns for your "actively managed" S&P 500 are in the column next to those for the total market, mechanical Wilshire 5000 index I referred to upthread. Torture the data a while, try to make them scream a bit. Amazing, isn't it? After 30 years (1975 to date), virtually the same average annual return. Virtually the same standard deviation. If that is active management, it is pretty darn good, matching the total market over 30 years! Or, is it that you want to find active management, no matter what?

Okay, (and sorry Norbert,) you'll have to add Arnott's backtesting to give a good comparison. On the one hand, I'm dubious about backtesting; on the other, all index returns dating before the actual introduction of total market index funds are dubious — they are in the "what would have happened" category.

Ah well, so you prefer to focus on doctrinal purity, or lack thereof, rather than results (the second part of my sentence that you did not quote): "which does not seem to affect tracking error to any great degree". Your choice. I look at minimal tracking error relative to an unmanaged investable index and see success.

Well, ya. So if it's not doctrinal purity, then you don't mind that the biggest ETF providers have extensive portable alpha programs that isolate index beta, and provide exotic beta (basically Fama-French value and small-cap factors) for a bit of a price? Or do you stick to your Tim Horton's. It's a choice, isn't it, between what you're familiar with, and getting used to variations on the same theme, and then, perhaps, a different theme. Tracking error is, (I'm not a skateboarder dude) so last year: now it's about liability-driven porfoltios, aka "show me the money," because the policy portfolios based on some strategic asset allocation aren't delivering the returns pension plans need to sustain retirement payouts. So, "tracking error" is a bit of a red herring — or a bit of a red flag before a bull of pension plan trustees.

Well and fine to buy VTI (and assume currency conversion costs, as well as the possibility of being taxed on death by US authorities), but then again, that's just a slice of the world's investable markets, and an overpriced one at that. Vanguard doesn't seem to have a total world market Viper. So, to capture the potential equity returns, one has to slice and dice, n'est-ce pas? Which index provider is best suited? Or do you prefer to have a large tracking error against worldwide returns, while having a minimal tracking error against a down US market?

[YogiBear]

More to the point, you seem to assume the U.S. is the market. At 48% of world market-capitalization, it's hard to miss; but remember, in 1989 Japan commanded the same market share, with the U.S. at about 35% IIRC. But I do agree with cheap total market coverage. Just not with S&P.

Uh, hello, upthread you were ranting about the "actively managed" S&P 500 and asserting that " all investable indexes are actively managed". So I responded WRT the US market (S&P 500, remember?!). The Wilshire 5000 is investable (although, as I noted, funds that track(ed) it tend to fudge the smallest companies in the index), and, as a total market index ("total market" as a descriptor of an equity index, er, ahem, usually refers to the entire investable equity market in one country, did you know?!), is "managed" according to very mechanical rules for inclusion/ exclusion, not "active" by any usual meaning of the word.

all index returns dating before the actual introduction of total market index funds are dubious — they are in the "what would have happened"

When did we start talking about specific funds? You were referring to the "actively managed" S&P 500- and as I noted, it tracks extremely closely over 30 years with the unmanaged, total market Wilshire 5000 index. The future- who knows? But those index returns were real, not dubious or "what would have happened"- so if the S&P 500 tracked the entire US market so closely over 30 years, what does that say about your oft-repeated thesis concerning the S&P 500?

"tracking error" is a bit of a red herring — or a bit of a red flag before a bull of pension plan trustees.

Not in the slightest- if one wants passive exposure to, for example, the US market, then the tracking error of whatever index instrument is chosen to provide that exposure is the only thing that matters (insofar as tracking error incorporates the cost of owning the fund in question)- the closer it tracks the chosen index, the better the implementation of that part of the strategy. Period. The larger issue is putting the various asset-class pieces together, of course, but that is a different story entirely.

Well and fine to buy VTI (and assume currency conversion costs, as well as the possibility of being taxed on death by US authorities), but then again, that's just a slice of the world's investable markets, and an overpriced one at that. Vanguard doesn't seem to have a total world market Viper. So, to capture the potential equity returns, one has to slice and dice, n'est pas? Which index provider is best suited? Or do you prefer to have a large tracking error against worldwide returns, while having a minimal tracking error against a down US market?

Since you clearly failed to understand the point of my prior posts, as just explained, there really doesn't seem much point in disturbing you further in your delusions, right/ n'est-ce pas/ nicht wahr (hey look, I'm playing your multi-lingual game too ...)?

[parvus]

yogi bear wrote:

parvus wrote:
More to the point, you seem to assume the U.S. is the market. At 48% of world market-capitalization, it's hard to miss; but remember, in 1989 Japan commanded the same market share, with the U.S. at about 35% IIRC. But I do agree with cheap total market coverage. Just not with S&P.

Uh, hello, upthread you were ranting about the "actively managed" S&P 500 and asserting that " all investable indexes are actively managed". So I responded WRT the US market (S&P 500, remember?!). The Wilshire 5000 is investable (although, as I noted, funds that track(ed) it tend to fudge the smallest companies in the index), and, as a total market index ("total market" as a descriptor of an equity index, er, ahem, usually refers to the entire investable equity market in one country, did you know?!), is "managed" according to very mechanical rules for inclusion/ exclusion, not "active" by any usual meaning of the word.

Dow Jones Wilshire:

To be included in the index, a security must be the primary equity issue of a U.S. company. Excluded are bulletin-board issues, because in general they do not have consistently readily available prices.

Presumably that also excludes prefs and convertible issues, besides the pink sheets. Not quite, to my mind, the total equity market. To analogize, some holders of certain shares are getting a better deal with CHUM's sale than others. That would seem to violate Miller-Modigliani, but it seems to me the capital structure of a firm matters, and provides different sets of investment opportunities that are not captured in an index, but are part of the economic opportunities market-cap-weighted indexes try, at least in abbreviated fashion, to capture (total market capitalization is, after all "indexical" for leading indicators forecasts).

In sum, there are active decisions being made, even if there are rules, and what is "investable" from an institutional or indexing standpoint may leave out large chunks of the market in securities. To take another example, when Cinar was busted, it still traded OTC, and was taken private at more than $3 a share. It's about to go public again. So, again, an investable opportunity was not "investable enough" for the index "bookies."

parvus wrote:
all index returns dating before the actual introduction of total market index funds are dubious — they are in the "what would have happened"

When did we start talking about specific funds? You were referring to the "actively managed" S&P 500- and as I noted, it tracks extremely closely over 30 years with the unmanaged, total market Wilshire 5000 index. The future- who knows? But those index returns were real, not dubious or "what would have happened"- so if the S&P 500 tracked the entire US market so closely over 30 years, what does that say about your oft-repeated thesis concerning the S&P 500?

Unmanaged?

Beginning with the September 2005 rebalance, US company definition for inclusion in the Dow Jones/Wilshire 5000 index will change. After the rebal­ance, it will include corporations that— for business reasons, says Dow Jones— are based outside of the US but consid­ered by the investment community to be headquartered in the US.

After the rebalance, the 32 compa­nies added to the index using the new definition will have a full-cap market value of $130 billion. About 65% of that is the combined market cap of the top three added names: Tyco Intl Ltd (NYSE:TYC), Ace Ltd (NYSE: ACE) and Marvell Technology Group Ltd (Nasdaq: MRVL).

As for the rebalancing of the S&P 500, you can read Jeremy Siegel's The Future for Investors. Sticking with the late 1950s components, some of which were dropped, would have yielded better returns than the "unmanaged," but "rebalanced" 500.

parvus wrote:
"tracking error" is a bit of a red herring — or a bit of a red flag before a bull of pension plan trustees

.

Not in the slightest- if one wants passive exposure to, for example, the US market, then the tracking error of whatever index instrument is chosen to provide that exposure is the only thing that matters (insofar as tracking error incorporates the cost of owning the fund in question)- the closer it tracks the chosen index, the better the implementation of that part of the strategy. Period. The larger issue is putting the various asset-class pieces together, of course, but that is a different story entirely.

Different, yes, but crucial for meeting liabilities. To wit, if you outperformed the benchmark, but still lost money, as against a return assumption of xx% .....your tracking error doesn't matter.

parvus wrote:
Well and fine to buy VTI (and assume currency conversion costs, as well as the possibility of being taxed on death by US authorities), but then again, that's just a slice of the world's investable markets, and an overpriced one at that. Vanguard doesn't seem to have a total world market Viper. So, to capture the potential equity returns, one has to slice and dice, n'est pas? Which index provider is best suited? Or do you prefer to have a large tracking error against worldwide returns, while having a minimal tracking error against a down US market?

Since you clearly failed to understand the point of my prior posts, as just explained, there really doesn't seem much point in disturbing you further in your delusions, right/ n'est-ce pas/ nicht wahr (hey look, I'm playing your multi-lingual game too ...)?

No, I understood. I'm just obstinate or wrong-headed or maybe just plain deluded that, while costs do matter, and benchmarking is important to gauge the value of performance, there's a whole world of investment matters that lie beyond simply choosing the best investable index — and yes, perhaps I cavil too much about degrees of active management, but remember S&P only included REITs beginning, gingerly, in 2001, and in Canada, income trusts only over the past year, meaning total market indexers missed four years of gains — such as a realistic estimate of the risk premium, to take one, and how to hedge liabilities for another.

Pedantically, he says, with Vanguard Vipers pen in hand (holy coincidence— 'struth).

That said: I'm willing to cut Arnott some slack; the other indexers aren't necessarily "pure." I like some indexing principles, but I'm not wedded to cap-weighting; I prefer total return indexes (since ~40% of historical returns derive from reinvested dividends); and I have a bias against growth stocks, or at least large-cap growth stocks — the glamour TMT folks.

[YogiBear]

Dow Jones Wilshire:

To be included in the index, a security must be the primary equity issue of a U.S. company. Excluded are bulletin-board issues, because in general they do not have consistently readily available prices.

Presumably that also excludes prefs and convertible issues, besides the pink sheets. Not quite, to my mind, the total equity market.

<snip>

In sum, there are active decisions being made, even if there are rules, and what is "investable" from an institutional or indexing standpoint may leave out large chunks of the market in securities. [emphasis added]

At the risk of playing semantics, the decisions made for the likes of the Wilshire 5000 are not "active", in the sense of ongoing adjustments in the face of developments external to the index as such, but rather are decisions "of first principle"- they establish the parameters under which the index will operate from the get-go, and should not be changed thereafter. The inclusion/ exclusion/ non-eligibility of any issue should be determinable objectively by reference to the criteria at any time by anyone. Whether you agree with the criteria, of course, is another matter- if not, you don't use that index, is all ...

As for the criteria, ISTM that "consistently readily available prices" is a valid and important consideration for inclusion. Including "the primary equity issue" of each company, while excluding prefs et al, gives exposure to the market performance of virtually all publicly traded companies with such price information. After all, is the index meant to track every equity issue, or every company? Do you define "total market" by every security that trades, or every issuer that is listed?

As for the rebalancing of the S&P 500, you can read Jeremy Siegel's The Future for Investors. Sticking with the late 1950s components, some of which were dropped, would have yielded better returns than the "unmanaged," but "rebalanced" 500.

In case it wasn't clear, I have never claimed that the S&P 500 is not managed- it clearly is, in some sense that I don't care enough about to attempt at defining. My comments about the S&P 500 were in response to your implication that the "active (mis-)management" of the index resulted in losses for investors that might not otherwise have taken place. As I pointed out, the aggregate results for the S&P 500 for 1975-2005 were remarkably similar to those for the Wilshire 5000, which does not have any "active" security selection process- which calls into question criticisms of the S&P selection committee as having destroyed value for investors tracking their index, at least for the period 1975-2005.

Different, yes, but crucial for meeting liabilities. To wit, if you outperformed the benchmark, but still lost money, as against a return assumption of xx% .....your tracking error doesn't matter.

Since we were talking about indices, postulating outperformance of benchmarks seems a touch oxymoronic. But when you mention "meeting liabilities" and "return assumption of xx%", you are into an entirely new subject matter- portfolio construction. To now, we have been discussing index construction and application, which presumes that we are considering asset classes individually, not as an aggregated portfolio. Your points are, of course, absolutely crucial at that level- but, WADR, irrelevant to a consideration of an individual index and the implementation of a passive strategy WRT it. At this level, the one we have been at from the start of this back-and-forth, "the tracking error of whatever index instrument is chosen [...] is the only thing that matters (insofar as tracking error incorporates the cost of owning the fund in question)- the closer it tracks the chosen index, the better the implementation of that part of the strategy."

I'm just obstinate or wrong-headed or maybe just plain deluded that, while costs do matter, and benchmarking is important to gauge the value of performance, there's a whole world of investment matters that lie beyond simply choosing the best investable index

Of course! I couldn't agree more! But "choosing the best investable index" was/ is the subject of this thread, and the basis upon which our discussion was started- I took issue with your assertion that "all investable indexes are actively managed". And "choosing the best investable index" is a mightily important affair, since it implies a number of conclusions about investment orientations- "whole market" vs "slice-and-dice", "tilt (small/ value)" vs "no tilt", nowadays "market cap" vs "constrained market cap" vs "fundamental", etc. And after that comes a whole new aspect to the issue- choosing the best instrument with which to implement that specific index choice as part of the overall, diversified portfolio, which raises a whole new set of considerations: some you raised WRT VTI (forex, withholding taxes, brokerage commissions, etc), and some I did generally (tracking error, costs). And of course, all of this takes place within the broader framework to which you alluded in your last post: "[putting the various asset-class pieces together is] crucial for meeting liabilities. To wit, if you outperformed the benchmark, but still lost money, as against a return assumption of xx% .....your tracking error doesn't matter." But no matter how important, that, as they say, is a story for another day.

[parvus]

Arnott conspicuously missing from the NYT.

August 15, 2006
Market Place
Real Money Rides on Bet on Basics of Investing
By JENNY ANDERSON
The gloves have come off in a debate over how investors can best capture the returns of the stock market.

The point of contention concerns indexing — ways that investors can efficiently buy large baskets of stocks that mirror significant segments of the overall market like the Standard & Poor’s 500-stock index or the Nasdaq composite index.

If the argument has become heated, it is probably because it may influence the direction of what has become a $5 trillion market, encompassing money invested in portfolios tracking popular indexes like the S.& P. 500.

Witness the debate between Jeremy J. Siegel, a professor of finance at the Wharton School and a senior investment strategy adviser to WisdomTree Investments, against John C. Bogle, founder of Vanguard Group, the mutual fund and indexing giant, and Burton G. Malkiel, a Princeton professor who wrote “A Random Walk Down Wall Street.”

According to Mr. Siegel, there is a “revolution” under way, a “new paradigm” in which the traditional indexes like the S.& P. 500 will make way for fundamental indexing, which constructs indexes based on measures like companies that pay dividends, rather than just a company’s size.

Perhaps not surprisingly, the company Mr. Siegel advises, WisdomTree, whose chairman is Michael H. Steinhardt, the legendary former hedge fund manager, has been active in developing these indexes and sponsoring exchange-traded funds based on them. WisdomTree has opened 20 E.T.F.’s on the New York Stock Exchange.

Today, WisdomTree will announce that another big name is joining its cause: Arthur Levitt, the former chairman of the Securities and Exchange Commission, will become a senior adviser to WisdomTree.

Mr. Siegel says the central problem with traditional index funds, which are weighted by market capitalization, is that they overweight overvalued stocks and underweight undervalued stocks. Historically, value stocks outperform growth stocks, so an index should be constructed to invest in the cheaper value stocks rather than the expensive growth stocks.

“We should be shifting to another paradigm to look at how markets work,” Mr. Siegel said in an interview. “I don’t think the price of a stock is always in line with fundamentals. I think there are a lot of factors, which helps to explain a lot of what we see in the capital markets.”

Mr. Bogle disagrees. “Beware when you hear about the new paradigm,” he said yesterday. “I think the claims they make are outrageous." He refers to some of the data provided to back up the premises of WisdomTree as “data mining.”

The goal of indexing has been to provide the return of the overall stock market to investors at a low cost. Indexers contend that over the long run, their approach will consistently beat that of higher-priced active managers and stock pickers. On this point, both Mr. Siegel and Mr. Bogle would agree.

But Mr. Siegel says indexes tied to fundamentals offer better returns and lower volatility than capitalization-weighted indexes. Those indexes were supposed to be the best reflection of the true value of stocks because the markets were “efficient” — that is, they incorporated all the information available and all that information was reflected in stock prices.

But Mr. Siegel says that the market has a lot of “noise” in it and that prices are not the best measure of true underlying value, making market-cap weighting inefficient. A rise in a stock’s price may not reflect a change in fundamental value, but a lot of noise in the markets.

Enter fundamental indexing. WisdomTree has created a family of indexes focused on dividend-paying companies and weighted to those companies that pay the highest dividends. According to Mr. Siegel, from 1964 through 2005, a total market dividend-weighted index of all United States stocks outperformed a market-cap-weighted index by 123 basis points (1.23 percent) a year, with lower volatility.

Mr. Bogle, however, argues that such fundamental indexing requires higher portfolio turnover, and results in less tax efficiency and higher expenses. Mr. Siegel’s figures do not include expenses or portfolio turnover, both of which he says are low and are in fact lower than in actively managed funds, but are not as low as with Vanguard’s traditional dirt-cheap stock index fund.

Mr. Bogle also argues that fundamental indexing will overemphasize small-value stocks. Traditionally, that would have been a good thing, but past performance is no guarantee of future returns.

“Do you want to swap certain success for success that may prove to be an illusion?” Mr. Bogle said.

He concedes that the S.& P. index has flaws: with those flaws, he says it beats three-quarters of actively managed mutual funds every year.

The bottom line? Portfolio turnover for WisdomTree indexes is about 20 percent, which is more than that for capitalization-weighted portfolios but significantly less than for any actively managed mutual fund. Expense ratios for WisdomTree E.T.F.’s range from 28 basis points to 58 basis points for international funds. According to Morningstar Inc., the expense ratio for the Vanguard 500 index fund is 18 basis points. For the average actively managed domestic stock mutual fund, it is 151 basis points.

All of which suggests that investors may well benefit from both low-cost approaches, Mr. Bogle’s and Mr. Siegel’s, different as they may be.

William J. Bernstein, co-principal of the investment management firm Efficient Frontier, described fundamental investing this way: “It has higher turnover and higher transactional expenses, and so you have to be rewarded for that with extra return. And I think fundamental indexing does that.”

Mr. Levitt seemed to agree.

“It’s hard to tell which formula will emerge as the strongest formula,” he said. “I rather suspect there’s room for both.”

[Bylo Selhi]

Today's the day Arthur Levitt becomes an ETF shill

Former longtime SEC chief to join little-known WisdomTree

Former SEC chairman and investor champion Arthur Levitt will be joining a company that hopes to revolutionize the investing world. Levitt, who holds the record as the longest-serving SEC chairman and who departed on Feb. 9, 2001, will announce on Tuesday he will advise the little-known firm WisdomTree Investments (WSDT). By joining the firm, Levitt is endorsing the explosion of exchange-traded funds (ETFs), which are mutual funds that trade like stocks and have been taking on regular index mutual funds. He will not be a board member but will educate investors about the firm's strategy. "I will be speaking to groups about the field in general and WisdomTree," he says... Siegel says having Levitt as an adviser will show that trusted names in finance support the approach. "People like to be associated with people they trust," he says...

[parvus]

From the horse's (or is it the motorcycle's) mouth:

We’ve been asked by quite a few folks about the recent Op-Ed pieces in the Wall Street Journal, by Jeremy Siegel and by Jack Bogle and Burt Malkiel, relating to Fundamental Indexes™. Rather than reply to a few dozen inquiries, I thought I might share my observations with everyone on our distribution lists. If this is of no interest to you, please reply with “Remove” in the Subject line, and I’ll make sure not to send this kind of material your way in the future. Thanks!!



As with Tom Petruno earlier this year in the LA Times, Jeremy Siegel likens the development of Fundamental Indexes™ to the Copernican revolution, moving the Earth out of the center of the universe. I find the Copernican analogy flattering, albeit substantially over-the-top: Copernicus reversed 1800 years of Aristotelian logic, and his writings were banned by the Vatican for almost 300 years, while the “cult of cap-weighting” has been with us a scant 50 years. That said, I do think this is a legitimately important idea, which adds value for theoretically robust reasons. I commend Siegel for his articulate and succinct presentation of this work and of the theoretical basis for the efficacy of Fundamental Indexing.



I read the Bogle/Malkiel assault on Fundamental Indexing™ with interest. I think of Jack Bogle as a mentor – indeed, I launched RALLC after a dinner conversation with him, partly because I’d seen his example of launching Vanguard at a like age. And Burt Malkiel serves on our Advisory Panel, though he’s also been on Vanguard’s board for many years. I knew of their views, though I was surprised by the dismissal of RAFI as a passing fad. I think they (and Vanguard) are missing a massive opportunity.



The logic is simple and compelling. If stocks differ from their unknowable true fair value – as they must! – then any weighting scheme that directly links portfolio weight to this pricing error – as cap-weighting does! – will have a return drag. The telling point is that, with roughly half the value bias of the Russell 1000 *Value* index, RAFI adds more than twice as much incremental return. The outperformance relative to the Russell 1000 Value is relentless, as is evident in the first graph below. Why? Because R1V’s value universe is still cap-weighted!



Similarly, the outperformance relative to the S&P Equal Weighted index is equally relentless, despite almost *no* small-cap bias in RAFI (today it actually has a large-cap tilt!) and a profound small-cap tilt in SP-EW (which is supposed to help returns!). Why? Because, while equal weighting severs the link between portfolio weight and over- or under-valuation – indeed, equal weighting severs the link between portfolio weight and anything! – we are equal-weighting a cherry-picked list of growth stocks. The S&P committee *never* adds a stock that’s deep-value or out-of-favor to their index; we’re equal-weighting a very biased list! See the second graph below.



Anyway, we’re in the early stages of a tidal wave of interest in this work. Assets that we and our licensees manage in this domain has grown from $100m at the start of 2005, to $800m at the start of 2006, to $3.5B today. I’d love to have Jack, as founder of the first cap-weighted indexed mutual fund, and Burt, as founder of the EMH, embrace our work. But, I recognize that that won’t happen until the whole world is on our side! Frankly, I’m less concerned about the nay-sayers, who will always abound with any new idea, than I am about the dearth of respect for intellectual property in this domain. But, I’m optimistic that this will be a minor side-show in the evolution of this work.

[parvus]

Bylo,
I'm surprised you're not reacting to Bernstein's apparent volte-face.

William J. Bernstein, co-principal of the investment management firm Efficient Frontier, described fundamental investing this way: “It has higher turnover and higher transactional expenses, and so you have to be rewarded for that with extra return. And I think fundamental indexing does that.”

[Shakespeare]

I'm surprised you're not reacting

ISTM that the really big change for some of the proponents is the acceptance that the market is not perfectly efficient.

[Bylo Selhi]

Bylo, I'm surprised you're not reacting to Bernstein's apparent volte-face.

Why? Dr B's done that before, e.g. both he and St Jack came out swinging against ETFs (Dr B because the BGI gang "couldn't shoot straight" and St J because they appeal to timers and traders) and soon moderated their initial positions. Just because I'm staying on the sidelines doesn't mean I'm ignoring the game.

P.S. Even if there was incontrovertible proof that fundamental indexing beats cap-weight by, say 2% CAR, there would still be many rational people who would not make the switch, e.g. those of us with large CG-appreciations in the latter.