What's the Right Way to Index?

The following article appeared in the October issue of Morningstar ETFInvestor, a monthly newsletter dedicated to making sensible use of exchange-traded funds. Learn more about Morningstar's newest publication.

Lately, a lively debate has sprung up in the indexing community over how stocks should be ranked in an index. That's not the sexiest of topics, but the debate picked up some public attention when it reached the editorial pages of The Wall Street Journal, where Jack Bogle, a respected indexing proponent and founder of Vanguard Group, squared off against Jeremy Siegel, a noted financial author and professor of finance at the Wharton School of Business of the University of Pennsylvania. Bogle argues for a continuation of the dominant practice in indexing--capitalization weighting, while Siegel contends that investors would be better off if the stocks in the indexes were ranked based on fundamental investment factors.

For years, stocks in most indexes have been ranked according to their market capitalization. (A stock's market capitalization is simply its stock price multiplied by its float, which is the number of shares freely available for trading.) So, for most index funds, the stock with the largest market capitalization in its universe is its largest holding. ExxonMobil XOM is the largest U.S. corporation, as measured by market capitalization, so it has the number-one spot in the S&P 500 and the Russell 1000.

If indexes are supposed to represent the broad market, then market-cap weighting makes intuitive sense. If an imaginary and very wealthy investor set out to buy the entire U.S. stock market, he'd of necessity own the stocks in the proportion that they are represented in the Wilshire 5000, a cap-weighted index that represents almost the entire U.S. stock market.

But a poor showing by large-cap index funds during the bear market exposed a glitch in the system. In 1999, the cap-weighted S&P 500 was caught owning a large slug of pricey tech stocks that had seen their market caps skyrocket in the late 1990s. Consequently, index funds that track that ubiquitous benchmark underperformed their peers during the ensuing sell-off. That provoked charges that capitalization-weighted indexes systematically overemphasize overvalued stocks and give short shrift to undervalued names, leaving index funds vulnerable to bubbles when valuations get really out of whack. Over the past couple of years, alternatively weighted indexes have cropped up with the goal of sidestepping that problem.

Fundamental Weighting Methods
The most interesting of these are the indexes that weight stocks using fundamental factors. Perhaps the most prominent of these is the FTSE RAFI US 1000, an index that ranks stocks based on four fundamental factors: sales, cash flow, book value, and dividends. ETF investors can get exposure to this new index through PowerShares FTSE RAFI US 1000 PRF.

Additional alternatively weighted index funds that have really caught on with investors are those that rank stocks according to dividends. IShares Dow Jones Select Dividend Index DVY was the first ETF to the market with this concept, and investors flooded it with cash. It now weighs in at a hefty $7.4 billion in assets. The popularity of that fund didn't escape the notice of other ETF providers, and it didn't take PowerShares, State Street, and Vanguard long to jump on the dividend bandwagon. What's more, an entire ETF complex has recently built up around the premise of dividend weighting: WisdomTree Investments rolled out a whole slate of dividend-weighted ETFs this summer.

These upstarts contend that their ranking systems are superior to capitalization-weighted indexes. Based on historical data, they all claim to outperform their cap-weighted counterparts by as much as 2 percentage points per year.PAGEBREAK