January 29, 2007 8:09

Fundamentally okay index funds

I've always thought index funds were pretty cool. On average, stock mutual funds do worse than unmanaged indexes like the S&P 500 and Russell 1000. So if you buy a fund that only trails the index by a teeny bit, as most index funds are able to do because of their super-low fees, you're already doing better than most investors.

But when the stock market goes certifiably nuts, as this country's did in 1999 and early 2000, indexes weighted by market value (as most are) can take you to some weird places. In those years the S&P 500 became to a large extent a tech-stock index, just as tech stocks were reaching prices to which most wouldn't return for years. "It was certainly the opposite of buy low and sell high," is how Jason Hsu, director of research and investment management at Research Affiliates, puts it.

I had breakfast this morning with Hsu, who with his boss Rob Arnott came up with the concept of what they call "fundamental indexing"--picking the largest companies by cash flow or revenue or book value or dividends (or a mix of the four) and sticking them in a fund weighted by size. Wisdom Tree, run by Jonathan Steinberg (a.k.a. Mr. Maria Bartiromo) and backed by the likes of Jeremy Siegel and Michael Steinhardt, was first to market with a has gotten the most attention for its line of dividend-weighted exchange-traded funds. But Research Affiliates' FTSE RAFI indexes, weighted by a mix of fundamentals, are now available were first to market as ETFs through PowerShares and as mutual funds from Pimco.

Most new investment "products" are just new ways to charge investors fees for services of dubious value. But these fundamental index funds seem to offer something new and useful. Jack Bogle and Burton Malkiel, though, have been dumping on them, most notably in a Wall Street Journal op-ed last summer (available on Bogle's blog). Their argument is that, while fundamental indexing would have outperformed conventional indexing in recent decades, there's no guarantee that it will forever. Plus, the fundamental index funds have so far charged higher fees than cap-weighted index funds.

Fine, so we shouldn't be chucking out all existing index funds and replacing them with these newfangled ones. But I'm a little nonplussed as to why Bogle and Malkiel have made such a big deal out of this. "The gold standard is still holding the stock market and holding it forever," is how Bogle put it when I talked to him about it earlier today. I'm deeply hesitant to contradict the man. So how's this: Fundamental indexing looks like a pretty good idea, at the very least as a supplement to conventional index funds. But if you want to be absolutely sure, give it 100 years or so to prove itself.