Fundamental Indexing vs. Traditional Indexing

Today, one of the biggest idea battles in investments is between fundamental indexing and traditional indexing.

The idea behind fundamentally weighted indexes is to weight stocks in an index by some “fundamental” measure of value. The notion originated with Pasadena, Calif., money manager Robert Arnott and it has since been taken up by others, notably Jeremy Siegel, a finance professor at the University of Pennsylvania’s Wharton School.

Traditionally, most market indexes have been weighted by market capitalization; a few have used equal weighting methodologies; and the most famous market indicator, the Dow Jones Industrial Average, uses a price-weighting system. In general, however, stock market indexes tend to be market-cap-weighted.

In traditional market-capitalization indexing you replicate an existing market exactly as it exists. Then you trust that you’ll earn the return of that asset class, less tiny fees. The best-known example of this is the Vanguard 500 index fund. The object of mockery when it was launched in 1976, it has done better than 70 percent of its managed large-cap blend competitors over the last 10- and 15-year periods. Along the way it has accumulated nearly $70 billion in assets.

Proponents of fundamental indexing argue that market-cap weighting overvalues the larger stocks and undervalues the smaller stocks, skewing the market. To capture the “true value of the market,” fundamental indexes weight components by dividends, book value, earnings or some other finance-driven metric or combination of metrics. The hope is that these measures are a better gauge of a company’s true worth, allowing fundamental index funds to sidestep the problem suffered by traditional index funds.

Back-testing from 1980 through 2005 showed that the idea appears to work. Wisdom Tree Dividend index returned 14.7 percent annually, while the Wilshire 5000 index returned 12.9 percent. Similarly, the Wisdom Tree Small Cap Dividend index returned a whopping 17.2 percent, while the Russell 2000 index returned 12.1 percent.

But, fundamental indexing is criticized as merely being value investing in disguise. In short, the back testing 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 performance.

Fundamental indexing most likely wouldn’t have received nearly so much attention if the idea had been put forward in the late 1990s, when value stocks were suffering a long stretch of horrendous performance.

While the initial wave of critics dismissed fundamental indexing as a glorified value-tilt strategy, scrutiny of the theories is just now becoming more intense.

The debate finds proponents and critics jousting over a variety of assumptions, including how efficient capital markets are and how prices revert to fair value.

Regardless of who wins the academic argument, fundamental indexing could remain in demand. The fact that it is well constructed, transparent and a low-fee way of capturing the market’s value premium will attract investors

Fundamental indexing may turn out to be a strategy worth looking into. Only time will tell. But even if it is a big winner, traditional index funds won’t be big losers. They will remain what they have always been: A surefire way to beat most active investors.