Fundamental Indexing: Less than Meets the Eye
This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.
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Is your fundamental index fund an overpriced value fund in disguise?
Index funds and exchange-traded funds based on various "fundamental indexes" have been around for a while now. In 2005, PIMCO launched a fundamental index fund subadvised by Research Affiliates' Robert Arnott and, soon after, WisdomTree launched ETFs that weighted stocks based on their dividends and earnings. This was innovative at the time as most of the prominent equity indexes then, including the S&P 500, were capitalization-weighted. Now, with a few years worth of real-world performance data for funds that utilize a fundamental strategy, we can see how they have performed versus traditional indexes and discuss how investors can use them.
According to fundamental indexing's proponents, cap-weighted indexes suffer from a flaw, even if one believes the market is relatively efficient in correctly pricing publicly traded securities over the long haul. They argue traditional indexes systematically overweight overvalued stocks and underweight undervalued stocks. A relevant example would be Sun Microsystems'
Looking Beyond the Spin
Paul Kaplan, vice president of quantitative research at Morningstar, has studied the subject and he wrote an award-winning paper in 2008 criticizing this promise of predictable outperformance. Notably, Kaplan showed that rather than having a clear theory, proponents of fundamental indexing "have only a conjecture that market-valuation errors are more variable than fair-value multiples." In essence, in order for fundamental indexing to work, the market has to systematically overprice securities as much as it underprices securities. In addition, Kaplan, like other researchers, has attributed much of the outperformance to the "value effect"--that is, that the indexes are biased toward value, and value has outperformed the market in this decade.
A Black Eye in 2008
Kaplan wrote his paper in the beginning of 2008, and by the end of the year, many of his concerns were realized. The S&P 500 lost 37%, the WisdomTree ETFs lost a similar amount, and PIMCO Fundamental IndexPLUS
Fundamental index funds are not a silver bullet. Research and experience now show that they not only have risks and returns that are similar to value-biased cap-weighted value indexes but they come with expense ratios that can be twice as much, too. Because they are really just value indexes, you should compare them with other value index funds and plan on similar performance.