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My Two Cents

New Index Funds

Chris Farrell Apr 10, 2007

Index funds are boring, right? Not quite. The index fund world is in turmoil.

The reason is a new generation of customized indexes. They’re based on dividends, earnings, book value, and other so-called “fundamental factors.” The new indexes are mostly sold as Exchange Traded Funds or ETFs.

These so-called “fundamental” indexes are challenging the primacy of traditional benchmarks like the Standard & Poor’s 500-stock index and the Russell 2000. Here’s an article I wrote for Business Week on the subject.

Briefly, the details in this fight are over index construction. Traditional indexes like the S&P are “capitalization-weighted.” That means the heft of each stock in the index is relative to the market value of its shares. In practice, the most highly valued companies–such as IBM–wield a disproportionate influence on the market performance of traditional indexes. The criticism is that traditional indexes can can become lopsided. For instance, during the height of the dot-com era, technology stocks accounted for more than 30% of the index, about double its historic average. That turned out to be a serious drag on returns when the bubble burst.

The capitalization-indifferent fundamentalist approach is less susceptible to such market mood swings and comes closer to ranking companies on their importance in today’s economy. But there are drawbacks. The most important is that fees tend to be higher, and fees matter a lot when it comes to long-term performance. The new indexes are also hybrid funds, tinged with an element of active management or perhaps, more accurately, active strategists. And it is true that the good performance of some fundamental index funds reflects that they were in the right market sectors over the past several years. But market enthusisam waxes and wanes.

Now, if you think I am kidding that this is a fight, Wall Street style, here’s John Bogle, the octogenarian founder of Vanguard. Bogle is a pioneer in bringing traditional indexing to individual investors. As you’ll see, he’s no fan of the new indexes. This excerpt comes from his new book, “The Little Book of Common Sense Investing”:

The new members of this breed are not shy about their prescience. They claim variously, if a tad grandiosely, that they represent a “new wave” in indexing, a “revolution” that will offer investors better returns and lower voaltuility, and a “new paradigm.” Indeed, they describe themselves as the new Copernicans, aftre the man who concluded that the center of the solar system was not the earth, but the sun. They compare the traditional market-cap weighted indexers with ancient astronomers who attempted to perpetuate the Ptolemaic virew of an earth-centered universe….. I recommend skepticism.

Here’s my takeaway: I still tend to lean toward the traditional indexes. I don’t think the “revolutionaries” have made their case yet. Still, I’m largely I’m agnostic on the debate. The reason: No matter what the individual investor comes out ahead.

Look, most investors own a mix of traditional index funds and actively managed mutual funds. Yet expenses on the fundamental indexes are less than half that of the average actively managed mutual fund. So, if fundamental indexes catch on, it could be at the expense of managed mutual funds, not traditional indexers.

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