Fundamental Indexing

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For these ETFs, the fundamental things apply

Firms, experts take sides in clash over best investment strategy

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Finding Value in the Fundamental Index ETFs

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For this one you'll either have to be a free member at Forbes or get a login id and password at bugmenot.com

The Index Insurgents

Scott Woolley, 10.30.06

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Financial Times (UK)

Alternative indices

Published: 12/10/2006

"Some see such benchmarks as quantitative investment strategies made transparent and accessible. But they do offer investors alternatives to traditional index-tracking. And if they consistently outperform in practice, it could raise the bar further for truly active fund managers selling their stock-picking expertise."

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One year later, exchange-traded funds disappoint

Harry Domash

Sunday, October 15, 2006

A year ago I described a new twist on exchange-traded funds marketed by PowerShares Capital Management, which appeared to have an advantage over the competition.

Last week, I checked on how PowerShares funds have performed over the past 12 months. Unfortunately, so far, the results have been mixed.

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Fundamental Indexing Becomes a Bit More Crowded

Posted on Oct 17th, 2006

First there was Rob Arnott and his firm, Research Affiliates, who now manage ETFs with a fundamental indexation strategy for PowerShares and Claymore. Then WisdomTree entered the market with their version of fundamental indexing although based on dividends while Arnott’s was a combination of dividends plus three other fundamental factors.

Now comes news of an ETF behemoth entering the market.

[AltaRed]

The difficulty I find with these new indices and funds is the higher turnover rate that will occur annually to re-balance, plus higher MERs (ERs) to manage the analysis and turnover. Perhaps the extra oomph fundamental indexing is supposed to provide will overcome expenses and cap gains from turnover.

After looking at a series of dividend weighted ETFs, e.g. DVY, SDY, PEY, FDL, VIG and DHS, for a month or two, I came to the conclusion that I may be better off with Vanguard VTV with low ER (0.11%), ~2.64% yield and (relatively) low turnover.

[Bylo Selhi]

Some years ago (late '90s) there was a company, First Trust, that introduced so-called Unit Investment Trusts. These bought and held a basket of stocks in some asset class or market sector based on some sort of "fundamentals" criteria. They had all sorts of impressive back-tested data that "proved" how their approach had outperformed target indexes in the past and used this to suggest that this would persist into the future.

First Trust Advisors’ approach to investing identifies underlying factors that have historically outperformed the stock market over long periods of time utilizing the FTA Proprietary Valuation ModelTM. Once a strategy is explicitly defined in terms of its underlying factors, it is backtested to determine historical risk/return characteristics relevant to a specific benchmark.The result is a disciplined investment approach that consistently applies strategies which are based on rational methods of selecting stocks and historical relationships in the market.

See also:
First Trust Portfolios Canada
First Trust Portfolios US

I'd almost forgotten about FT until the recent interest in fundamental indexing. When introduced in Canada these UITs were heavily promoted by brokers, at least in part because they paid a hefty sales commission and annual trailer. I haven't heard anything about them in years. Anyone know how investors made out? (I'm a cynic, so I think I already "know" the answer to that )

Why should fundamental indexing be any different?
And even if it is different, why should we jump on the bandwagon now based only on backtested data?
Should we not wait a few years to see if these techniques work out in the real world, after disclosure of methods, after fees, after turnover, after taxes, etc?

[Taggart]

Why should fundamental indexing be any different?
And even if it is different, why should we jump on the bandwagon now based only on backtested data?
Should we not wait a few years to see if these techniques work out in the real world, after disclosure of methods, after fees, after turnover, after taxes, etc?

...and how long would you wish us to wait?

Examining The Income Component of Total Returns

Dividends and The Three Dwarfs

Why Dividends Matter

[Rip]

1) Line up all the stocks in an index.
2) Overlay a filter of some description for the puposes of screening out stocks deemed unattractive.
3) Buy the rest.

This sounds like active mgmt to me. Interesting how the ingrained desire to improve, to not settle for the average, just keeps rearing it's ugly head.

[$seeker]

Bylo Selhi is correct on Fiest Trust
I have held their Dogs of Dow portfolio and the Pharma trust for toooo long and they were both dogs . One of the reasons for leaving advisor and finding this and other sites promoting DIY . I have had no returns in years so I figure I may as well lose the money all by myself rather than pay someone to do it for me!!!!

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Morningstar - U.S.A.

By Sonya Morris, CPA | 12-12-06

What's The Right Way to Index?

Our take on the newest breed of index funds.

[NormR]

Bylo Selhi is correct on Fiest Trust
I have held their Dogs of Dow portfolio and the Pharma trust for toooo long and they were both dogs .

Might have been the fees & currency ...

These dogs are barking

In fact, you'd be riding high all around. This year, the Dogs are whipping just about every index out there. The surging Dow Jones industrial average, the Dogs' main benchmark, might have been up 15% at the end of October. But the Dogs were showing a return of almost 30%.

[Bylo Selhi]

Might have been the fees & currency ...

Mighta, cudda, shudda, etc. But in any case that speaks only to the Dow Dogs. The First Trust portfolios invested in a lot of other "back-tested" stuff, both domestically and overseas. If they were even half as much a "sure thing" as the advertising suggested then you'd think we'd be seeing their impressive performance stats in newspaper and magazine ads now. But alas, we don't. Hmmm....

As for the fees, IIRC they were lower than conventional DSC funds. Besides, according to the impressive back-tested data, the outperformance was supposed to be several percentage points better than the benchmarks, so the usual "fees don't necessarily matter" industry [s]mantra[/s]bullshit must have undoubtedly held, eh?

[NormR]

Might have been the fees & currency ...

Mighta, cudda, shudda, etc. But in any case that speaks only to the Dow Dogs. The First Trust portfolios invested in a lot of other "back-tested" stuff, both domestically and overseas. If they were even half as much a "sure thing" as the advertising suggested then you'd think we'd be seeing their impressive performance stats in newspaper and magazine ads now. But alas, we don't. Hmmm....

As for the fees, IIRC they were lower than conventional DSC funds. Besides, according to the impressive back-tested data, the outperformance was supposed to be several percentage points better than the benchmarks, so the usual "fees don't necessarily matter" industry [s]mantra[/s]bullshit must have undoubtedly held, eh?

Ah Bylo, I'm not the biggest proponent of the Dogs (nor of overly complicated back testing). I'd guestimate that you can probably pick up (very roughly) about 2% via a dog-like approach. These days you can just buy a dividend etf or buy the stocks directly and keep the fees low.

However, many people in U.S. funds/etfs are probably smarting from USD/CAD over the last 5 years (about a 36% move in total according to the Bank of Canada). Even the S&P500 is down 0.5% annually according to globefund over the last 5 years (vs a gain of 13.3% for the S&P/TSX60). Most (non-hedged) U.S. funds/etfs look bad over the last 5 years.

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New York Times

How to Corral an Index Fund (With a New Rope)

By PAUL J. LIM
Published: January 21, 2007

INDEX funds used to be simple. In fact, ever since indexing rose to prominence as an investment strategy in the late 1990s, simplicity has been a big selling point.

Traditional index funds remove much of the emotion and ego from investing. You buy and hold all the stocks that make up a market benchmark and achieve average returns, rather than trying to beat the market through active stock picking. There’s not much to it — and that’s been indexing’s strength.

But a group of market theorists have emerged recently with a take on indexing that complicates matters considerably. These so-called fundamental indexers say they can beat the market, not just match it, a core assertion that certainly seems to inject some ego back into the process.

Fundamental indexers say it’s not a matter of being smarter than the market, but of using common sense. They say it is possible to outperform traditional yardsticks like the Standard & Poor’s 500-stock index simply by reconstructing the benchmarks that the funds mimic — by reweighting an existing index or building a new one.

To followers of traditional indexing, the very notion of trying to beat the market by indexing the market is heresy — not to mention illogical. “It just doesn’t make sense,” said John C. Bogle, founder of the Vanguard Group, which started the first retail index fund, the Vanguard 500 Index, 30 years ago.

And to many investors, the distinctions between fundamental and traditional indexing may seem arcane. Both broad strategies call for buying and holding a diversified basket of stocks for the long run. And both try to keep costs down by avoiding active stock picking.

But traditional index funds tend to mimic indexes weighted by market capitalization, such as the S.& P. 500 or the Russell 1000 index of large stocks. In a cap-weighted index, stocks with greater market values have greater sway over the index’s performance. As the price of a stock rises, a traditional index fund reflects that rising value. Conversely, if a stock’s price drops, the value of the holding in a traditional cap-weighted fund will also fall.

What’s wrong with this approach? Well, what if the market isn’t always right — and misprices stocks from time to time?

Jeremy J. Siegel, a finance professor at the Wharton School of the University of Pennsylvania, said the bubble that formed in technology stocks in the late ’90s “really began to show how far stocks can be pushed away from their fundamental value.”

“We saw the biggest mispricing of equities in stock market history,” he said. Yet cap-weighted index funds put investors at risk by building their technology positions as the market became frothier and frothier. Then, when the Internet bubble burst, those investors saw those huge tech stakes get slammed.

That’s just the nature of the beast, said Robert D. Arnott, chairman of Research Affiliates, an investment management firm based in Pasadena, Calif., that is a major proponent of fundamental indexing. “With cap weighting, anything that is overvalued is overweighted by the index, and anything that’s undervalued is underweighted.”

Mr. Siegel and Mr. Arnott say they believe that there is a better way. They suggest that instead of building an index based on market capitalization, it is better to use fundamental factors such as earnings, dividends or cash flow to determine how much of a security the index fund should own.

In a momentum-driven market like that of the late 90s, such a strategy could lag, fundamental indexers say, because investors wouldn’t be riding the wave. Conversely, the strategy should hold up better in a falling market, because fundamental indexes were not as likely to be caught up in market hysteria.

“In a fundamentally weighted index, you don’t become a speculator,” said Bruce Bond, chief executive at PowerShares Capital Management, which recently opened several exchange-traded funds based on fundamental indexes created by Mr. Arnott’s firm, Research Affiliates. Over the last year, the number of exchange-traded index funds that adhere to this new approach has risen to around 50 from just 7, according to State Street Global Advisors.

But there is no denying that this new approach forces investors to make several layers of decisions.

For example, after deciding that indexing — and not active stock-picking — is the best way to go, you must decide which type of indexing to choose — fundamental or traditional. If the choice is fundamental indexing, you must decide which fundamental factors — earnings, sales, dividends or cash flow, for instance — are most important. Then comes another decision: Which recipe for a fundamentally weighted index is best, based on those variables?

There are already squabbles forming about whose theories of alternative indexing are superior. Wilmington Trust recently opened two retail mutual funds that tracked fundamentally weighted indexes. The indexes rely on three variables: dividends, free cash flow and net income.

By contrast, Mr. Siegel — who serves as senior investment strategy adviser to WisdomTree Investments, which has started 30 fundamental index funds — prefers to focus on dividends. Why dividends? They are “just about the only valuation metric where there is no dispute — where there’s no management manipulation,” he said. Mr. Siegel added that not only do dividend-paying stocks perform better than nonpayers over the long run, they also tend to fare better in bear markets.

BUT Mr. Siegel’s competitors point out that WisdomTree recently filed to register a new set of fundamentally oriented E.T.F.’s that weight stocks based on earnings. This would imply that WisdomTree doesn’t believe that dividends are the best way to weight an index in all circumstances. And Mr. Siegel agreed in a recent interview that “it’s wrong for me to say blanketly that it’s the best for everyone at all times.”

For his part, Mr. Arnott said he thought that a dividend-only model, while potentially effective in beating the S.& P. over the long term, could create portfolios that were not as broadly diversified as other funds. As an alternative, Research Affiliates has constructed several fundamentally weighted indexes using a combination of sales, cash flow, dividends and book value. Based on records from the last four decades, Mr. Arnott said, the Research Affiliates Fundamental Index 1000, a large-cap index, would have handily beaten the S.& P. 500. From 1962 to 2006, the RAFI 1000 would have generated an average annual return of 12.5 percent, versus 10.4 percent for the S.& P.

But Mr. Bogle said that “these are hypothetical returns for the underlying indexes that don’t take into account fees, costs and taxes” that would be associated with running an actual index fund. What’s more, he said, many fundamental index funds charge more in fees and have higher turnover rates than traditional index funds like the Vanguard 500.

Some critics say that the fundamentals approach isn’t really indexing at all. After all, they contend, a fundamental index provider has to select a method for weighting stocks that it thinks is superior to the collective wisdom of the market.

“What they’re doing is active management,” said Clifford S. Asness, managing principal at AQR Capital Management in Greenwich, Conn.

And because of the emphasis on fundamental factors rather than market capitalization, he said, it is a form of active management that tends to favor value-oriented stocks and smaller stocks.

Mr. Arnott argues that fundamental indexing is a form of passive investing — that it simply ranks stocks based on their “economic footprint” rather than market capitalization.

Dodd F. Kittsley, director of E.T.F. research at State Street Global Advisors, said that while there were certain “active components” to this strategy, it remains a version of indexing. But he wonders how recent market trends may have affected the results of the approach.

“I don’t think it’s ironic,” he said, “that a lot of these fundamental index funds with a value and small tilt have come out at a time when value and small stocks have been doing extremely well.”

At the very least, it may be too early to tell how good these fundamental index funds are, especially because many lack even a one-year track record. “I’m holding off to see if these funds perform all that differently at the end of the day relative to traditional cap-weighted funds,” said Sonya Morris, editor of the Morningstar ETF Investor.

David R. Kotok, chairman and chief investment officer at Cumberland Advisors in Vineland, N.J., has begun investing some of his clients’ money in fundamentally weighted index funds.

But he has refrained from shifting his entire strategy to them, he said.

“These are new vehicles,” he said. “We just don’t know for certain how they’ll perform.”

[parvus]

Durn Taggart,

You're spoiling tomorrow's read for the ink-stained wretches like me.

[Taggart]

Durn Taggart,

You're spoiling tomorrow's read for the ink-stained wretches like me.

Sorry about that Parvus. Normally, I don't like posting the whole article (except when there's a possibility in the near future they may lock it up to be read by paid subscribers only). Now you know why I've gone underground.

[parvus]

Not to worry. I'm just joshing. I post the full-length versions all the time, since they go under lock and key in a week. Just not usually a day ahead.

(Since I'm a religious NYT reader, I was dumbfounded I hadn't seen that article, till I looked at the publication date!)

I will scroll through the NYT site on Saturdays when I'm too lazy to go pick it up (an eight-minute walk ). Lately, the Globe has delivered the daily for $2 a week (and then, I'm sure, they'll jump it to $13 (in 2001, they jumped it to $18, from $11, and later boosted it to $22), even though the newstand price is $9 ).

When I scroll through the site on Saturday, I usually leave alone Sunday's articles, since it would be a shame to throw out that much newsprint without having fingered all the pages the next day.

But, don't let me stop you in posting; some of those Sunday business articles are very, very good (hell, even my wife, who despises all things businessy, likes them) and worth sharing. I'll enjoy the print version tomorrow with the morning coffee.

[Taggart]

(Since I'm a religious NYT reader, I was dumbfounded I hadn't seen that article, till I looked at the publication date!)

It was just a fluke. Sometimes I'll search for something new in a search engine, using keywords, and most of the time there's nothing. This one was caught unexpectedly.

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Getting Index Weighting Straight

By Roger Nusbaum
RealMoney.com Contributor
1/23/2007 1:53 PM EST

"The argument over cap-weighted indexing vs. fundamental indexing rages on. And with the plethora of ETFs available employing either one, the debate appears to be an important one. However, most articles seem to add very little new information, leaving the central question yet to be addressed: Should you care?

Over the weekend, an article in The New York Times ably demonstrated what I'm talking about."

[Bylo Selhi]

Yet another way to index fundamentally: The Global 100 Most Sustainable Corporations in the World

Code: Select all

Outperformance Results

          MSCI   Global Outperformance
          World  100
1 year    10%    23%    13.46%
3 year    19%    25%     5.47%
5 year     3%    10%     7.11%

I don't see an ETF that tracks this index. Perhaps this is an opportunity for RAFI, PowerShares, Claymore, etc.

[Maciek]

Yet another way to index fundamentally: The Global 100 Most Sustainable Corporations in the World

Code: Select all

Outperformance Results

          MSCI   Global Outperformance
          World  100
1 year    10%    23%    13.46%
3 year    19%    25%     5.47%
5 year     3%    10%     7.11%

I don't see an ETF that tracks this index. Perhaps this is an opportunity for RAFI, PowerShares, Claymore, etc.

Have you checked out the PDF describing the methodology? Some of the fundamentals seem kinda, well, "fuzzy"

[Bylo Selhi]

Have you checked out the PDF describing the methodology?

Nope. I have no interest in investing in any of the indexes du jour.

My theory is that if you float enough ETFs based on enough different "fundamental" criteria, in 10, 15, 20+ years there will very likely be at least one that outperformed the S&P500 or MSCI World or whatever is the most appropriate benchmark. So, as the sponsor of such ETFs, you're almost guaranteed to have at least one winner no matter what.

Of course, I may just a natural cynic

[tidal]

Yet another way to index fundamentally: The Global 100 Most Sustainable Corporations in the World

Code: Select all

Outperformance Results

          MSCI   Global Outperformance
          World  100
1 year    10%    23%    13.46%
3 year    19%    25%     5.47%
5 year     3%    10%     7.11%

I don't see an ETF that tracks this index. Perhaps this is an opportunity for RAFI, PowerShares, Claymore, etc.

Have you checked out the PDF describing the methodology? Some of the fundamentals seem kinda, well, "fuzzy" :)

You want the fuzzy? You can't handle the fuzzy!!! From IndexUniverse last week, excerpt:

IndexIQ: Indexing Intangibles

In one of the more unusual ETF filings in recent months (and that’s saying something), a group called IndexIQ has filed for 20 new ETFs that try to take indexing in a whole new direction. Rather than being based on traditional market factors like market capitalization, or even more specific targets like “growth,” “value,” or dividend payouts, the IndexIQ ETFs will track indexes based on what might be called "intangibles”: measures like "Innovation," Power" and "Most Productive."

The funds included in the filing are:

IndexIQ Most Innovative Companies All Cap Index
IndexIQ Most Innovative Companies Small Cap Index
IndexIQ Most Powerful Companies Index
IndexIQ Most Powerful Companies Large Cap Index
IndexIQ Fastest Growing Companies All Cap Index
IndexIQ Fastest Growing Large Cap Companies Index
IndexIQ Best Operating Companies All Cap Index
IndexIQ Best Operating Companies Large Cap Index
IndexIQ Most Productive Companies All Cap Index
IndexIQ Most Productive Companies Large Cap Index
IndexIQ Most Elite Workforces All Cap Index
IndexIQ Most Elite Workforces Large Cap Index
IndexIQ Best Corporate Governance All Cap Index
IndexIQ Best Corporate Governance Large Cap Index
IndexIQ Competitive Momentum Leaders All Cap Index
IndexIQ Competitive Momentum Leaders Large Cap Index
IndexIQ Customer Loyalty Leaders All Cap Index
IndexIQ Customer Loyalty Leaders Large Cap Index
IndexIQ Most Sustainable Companies All Cap Index
IndexIQ Most Sustainable Companies Large Cap Index

Amazingly: "IndexIQ says these intangible attributes... represent many of the strongest drivers of... equity returns."

[IdOp]

My theory is that if you float enough ETFs based on enough different "fundamental" criteria, in 10, 15, 20+ years there will very likely be at least one that outperformed the S&P500 or MSCI World or whatever is the most appropriate benchmark. So, as the sponsor of such ETFs, you're almost guaranteed to have at least one winner no matter what.

What a great idea, the "incubator index"!