Is There A Better Way For Index Investors?





Is there a better way for investors to index their portfolios?

A bitter fight is breaking out over just that question.

In one corner sits John Bogle, founder of the Vanguard Group. He believes that index funds should hold stocks in proportion to each stock’s market capitalization – the market value of all the company’s shares.

In the opposite corner sits Rob Arnott, who co-authored The Fundamental Index: A Better Way To Invest, with Jason Hsu and John West. They believe that indexes should ignore market caps and hold companies in proportion to each firm’s fundamentals – things like cash flow or book value.

The spat between Mr. Bogle and Mr. Arnott may sound like an academic debate, but the outcome could have a large effect on your portfolio results.

Please read the rest of the article at The Globe and Mail








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  1. Justin Bulger

    says on April 23, 2013

    Hi Andrew,

    I just recently read your book and I really enjoyed it. I am currently a young supply teacher and am hoping to follow in your footsteps. What is your opinion on fundamental index funds vs. market-cap index funds? This article is obviously pro fundamental funds but is the research that conclusive that they are better overall?

    Thanks for the response,

    Justin

    1. Andrew Hallam

      says on April 23, 2013

      Hi Justin,

      Well, as I explained in the article, the evidence does seem to point in that direction. And as mentioned, I am adding them to my portfolio, but not selling what I have to do so. I do recommend the book mentioned in the article–fascinating stuff. And if my fundamental indexes outperform over the next five years, as mentioned, I will be making the switch.

  2. Canadian Dividend Bl

    says on April 23, 2013

    Why not equal weighted ETFs? If I was to invest in Royal Bank and National Bank, I wouldn't likely buy 80 shares of Royal Bank for every 10 shares of National Bank. I would likely buy 45 shares of each. It's simple, doesn't require complicated or interpreted calculations, and potentially lets you gain exposure to smaller companies in a diversified manner.

    1. Andrew Hallam

      says on April 23, 2013

      That certainly does make sense, Canadian Dividend Blogger. But such an index would have a much greater small cap weighting than anything other than a specific small cap index. To weight Johnson & Johnson the same as Papa John's Pizza seems a bit odd….but then again, the index won't likely fall victim to the overvaluation that cap based indexes do, in this case. That said, it would be nearly as volatile as a small cap index and many investors would dislike that. I would personally prefer a fundamentally weighted index than one that was equally weighted.

    2. Value Indexer

      says on April 25, 2013

      The research seems to show that equal-weighted indexes do indeed outperform traditional ones – but a fundamental index that uses some other form of weighting can do even better. Equal weighting also seems to generate more transaction costs since any rise or fall in a stock price relative to the market will require trading.

      I do use an equally-weighted index for Canadian REITs because there aren't that many of them but in most cases I would look for a fundamentally-weighted index instead. Like Andrew I have a portfolio that's in regular index funds but I'm looking at using new additions to build up a fundamental portion.

  3. Lee Atkinson

    says on April 24, 2013

    Hi Andrew,

    I thought you might be interested to see that even the mainstream media here in the UK is finally waking up to Index Funds.

    A recent study has found that only 38% of managed funds beat their appropriate UK All Share Index over a 10 year period.

    http://www.dailymail.co.uk/money/investing/articl

    1. Andrew Hallam

      says on April 24, 2013

      That's good to see. Thanks for the link Lee. I'm also assuming that this data is before survivorship bias.

      Cheers,

      Andrew

  4. Roger

    says on April 24, 2013

    Hi Andrew

    I enjoyed reading this article. Even thought CRQ has outperformed XIU, it is even more concentrated in Financials and Energy than XIU and just as poorly diversified. Would the investor not be taking on extra risk in the hopes of better future returns? I am a new DIY investor and just trying to understand these new indexes. Any insight would be greatly appreciated.

    1. Andrew Hallam

      says on April 24, 2013

      That might be the case Roger. The Canadian market has always been a bit heavy in Financials and Energy. I hear much concern about this, but the bottom line is this: the Canadian market itself (despite this leaning) is no more volatile than the U.S. market. We have decades of history suggesting they are similar in volatility. And volatility itself–even if it was greater–doesn't necessarily mean greater risk. If you have a global portfolio of bonds, U.S. stocks and International stocks (via indexes) as well as a Canadian index, the concentration of that Canadian index in financials or energy doesn't necessarily mean that your globally diversified portfolio is skewed. The fundamental index will prevent stocks like Nortel (remember 1999?) taking a huge amount of the weighting because it's based on the economic footprint, and not on market cap. What do you think?

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    says on April 28, 2013

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  7. Paul

    says on April 28, 2013

    Andrew, when you buy the fundamental ETFs which are you likely to buy? The ones you mention in the article? Just US and EAFE?

    1. Andrew Hallam

      says on May 3, 2013

      Paul and Kunwak,

      This link provides Canadian, U.S. and International indexes on the TSX: http://ca.ishares.com/product_info/fund/overview/

      1. Jonathan

        says on May 3, 2013

        What if I'm Singaporean, if i want to follow Fundamental Indexing, instead of A35, VTI, VEA, what should be my portfolio like? Does fundamental indexing only available on Toronto Stock Market and not in any other market?

        Thanks Andrew for your help.

        1. Andrew Hallam

          says on May 3, 2013

          Hi Jonathan,

          Fundamental indexes are also available on the New York Stock exchange, so you could buy them from a Singaporean brokerage. Schwab will be creating some Fundamental ETFs soon, and I suspect that they will undercut the costs of those available. That, of course, is just conjecture, however. If you want a long list of Fundamental ETFs available off the New York Stock Exchange, here's one for you on page 2 of this linked PDF: http://invescopowershares.com/pdf/P-FUNDAMENTALS-

  8. Kunwak

    says on April 29, 2013

    Hi Andrew, what are your choices to replace VTI and VEA?

    1. Andrew Hallam

      says on May 2, 2013

      Hi Kunwak,

      I mentioned them in the article–which I would have to read again to quote the names for you.

      Cheers,

      Andrew

  9. Jonathan

    says on April 29, 2013

    Hi Andrew, If I will replace my ISHG (World Bonds Index), VTI (US Index) and VEA, what is the best (and cheapest) ETF?

  10. Loydis

    says on May 5, 2013

    Hi Andrew,

    There is an article about this subject that was written by John Bogle and Burton Malkiel back in June 2006. The article is call: Turn on a Paradigm. You can find it on google.

    Let me know what you think.

    Loydis

    1. Stig

      says on May 5, 2013

      Thanks for suggesting the article Loydis – a very interesting counter-argument.

      Andrew, I too am very curious about your response to the points raised by Bogle/Malkiel, especially in the context of the 5-year comparative results you presented (I like the comments about reversion to the mean and the line, "Never think you know more than the markets. Nobody does.")

      Here is a direct link to the WSJ article:

      http://online.wsj.com/article/SB11513745438469150

      Stig

  11. Kelvin

    says on May 6, 2013

    Hi Andrew

    You mentioned Claymore’s Canadian Fundamental ETF and Claymore’s U.S. Fundamental ETF as replacements but not really replacements for VTI and VEA? Could you validate?

    I am thinking of splitting my global equity portion 50:50 between a cap weighted and fundamental weighted for a start first.

    I believe the Singapore STI does not have fundamental weighted versions, right?

    Cheers,

    Kelvin

  12. Daniel

    says on May 6, 2013

    Interesting post. I'll be following your blog to see if you ultimately decide it is worth it to go with the fundamental indexes. Their higher MER fees are going to be the deciding factor. . how much those will eat into your profit.

  13. Stig

    says on May 6, 2013

    Speaking of fees on fundamental indexes, iShares just released a new value-weighted ETF (broad US market), with fees of only .15.

    Ticker symbol is VLUE.

  14. Jeannie

    says on May 10, 2013

    Hi Andrew,

    Very interesting article. I did some research after reading this. It seems like tracking error, higher MER and tax efficiency (I'm Canadian) are the main concerns with fundamental indexes right now. Personally, I feel like there are not enough products in this category or they are too new (Correct me if I'm wrong). It will be interesting to be how the opinions might change in the next few years.

    Side note: I have just finished your book yesterday. Great job! To me, it's a excellent blend of entertaining and informative.

    1. Andrew Hallam

      says on May 10, 2013

      Thanks Jeannie,

      I find the tracking error argument a bit bizarre. I too, have read that from one source. The article in question made it look like the tracking error caused underperformance, versus cap-weighted index equivalents. But….the bottom line is that after tracking errors, after expense ratios and even after the taxable costs, fundamental indexes have outperformed cap-weighted products. I think that should be the only benchmark worth considering. Will they continue to, in the future? I don't know. But if you want to do some in-depth reseach, I recommend the book I highlighted in the article.

      Cheers,

      Andrew

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