Andrew Hallam is the index investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.
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.
Chances are, if you're an index investor, your investments are weighted by market capitalization, just as Mr. Bogle likes. It's the most popular way of building an index. But that doesn't necessarily make it the best way.
Fundamental indexers point out that a big market capitalization is no indicator that a company will perform well. In fact, the ten largest companies by market cap in the S&P 500 have typically underperformed the market. This trend has occurred during every rolling ten-year period, back to 1926.
A fundamental index, rather than emphasizing market size, weights its holdings based on cash flow, book value and dividends. Doing so, according to Mr. Arnott, ensures the index doesn't fall victim to fads, which can drive up a stock's price and therefore its market capitalization.
Apple is a prime example. Its popularity fueled its stock price, making it the biggest company on the U.S. market. Consequently, its plunge since September had a larger drag on Mr. Bogle's cap-weighted index than it did on an Arnott-inspired fundamental index.
So what's not to like about fundamental indexing? In an interview with the research firm Morningstar, Mr. Bogle called the strategy "witchcraft." His beef is that it's too much like active investing, with higher costs than Bogle-style indexing and higher fund turnover.
Back-tested studies of fundamental indexes, however, have been impressive. Between 1984 and 2004, a study of 23 different markets found fundamental indexes triumphed consistently over cap-weighted MSCI indexed benchmarks.
But back-tested studies are theoretical. They don't compare actual products available to investors.
Two such products are Claymore's Canadian Fundamental ETF and Claymore's U.S. Fundamental ETF, both trading on the TSX. With expense ratios of 0.72 per cent, they're pricier than their cap-weighted counterparts.
I decided to see how their performance would match up with the closest cap-weighted equivalents over the past few years.
Claymore's Canadian Fundamental ETF averaged 4.65 per cent over the five years ending Feb. 28, compared to just 1.19 per cent for the iShares S&P/TSX 60 ETF, which uses a cap-weighted index. So Round One in the indexing fight goes to Mr. Arnott.
Claymore's U.S. Fundamental ETF earned 2.94 per cent annually over five years, compared to 2.63 per cent for the cap-weighted iShares U.S. ETF. Mr. Arnott wins again.
Trading on the U.S. market, Powershares FTSE RAFI U.S. 1000 Fundamental Index earned 6.68 per cent compared to 5.53 per cent for Vanguard's Total Stock Market ETF.
If not for the Powershares FTSE RAFI Developed Markets ETF it might have been a perfect sweep. It lost 1.73 per cent per year, compared to Vanguard's cap-weighted equivalent, which dropped 0.92 per cent. So Mr. Bogle takes the fourth round after losing the first three.
Overall, though, it looks as if many fundamental indexes are besting their cap-weighted counterparts. I won't be switching my personal portfolio to fundamental indexes yet, but I will start adding them to my portfolio. If they outperform my cap-weighted indexes over the next five years, then I'll likely be making the switch.
Andrew Hallam