Fundamentally Based Indexes - Criticisms and Responses

Criticisms and Responses

Since the first research was disseminated, fundamentally based indices have been criticized by proponents of capitalization weighting including John Bogle, Burton Malkiel, and William Sharpe. The opposing opinions rely heavily on opposing assumptions. Proponents claiming a new revolutionary paradigm in index fund investing such as for example Robert D. Arnott, Jeremy Siegel and Jack Treynor — all affiliated with fundamental index funds — assume somewhat irrational markets whereas the opponents mentioned — some affiliated with conventional index funds — assume more rational and efficient markets. Responses to criticisms have come primarily from the publications of one of the founders of fundamentally based indices, Robert Arnott.

• Fundamentally based indexes are really being actively managed. By avoiding capitalization weighting, they are making bets that certain stocks will outperform the market.
  • Response: Although not necessarily generalizable, referring to his own company’s fundamentally based indices, Robert Arnott said, “Our fundamental index is formulaic, transparent, and is objectively and rigorously constructed.... The S&P 500 is not objective. It is not formulaic. It is not transparent. And it is not replicable.”

• Fundamentally based indices are exposed to the Fama–French risk factors—that is they are value-biased and small cap-biased. These factors have historically led to outperformance. The current returns of fundamentally based indices are exaggerated because of the recent strong performance of value stocks during the last 30 years and the outperformance of small cap stocks.
  • Response: It is true that the Fama French factors explain much of the returns of fundamentally based indices as they do for most passive portfolios. If they did not, it would demonstrate a flaw in the Fama French model. After controlling for Fama French risk factors, fundamentally based indices exhibit a small positive alpha—-albeit a statistically insignificant one—-as compared to other value-biased indices that exhibit negative alpha like the S&P 500 Equal Weight or the Russell 1000 Value.

• Fundamentally based indices have higher turnover and therefore higher costs than capitalization weighted indices.
  • Response: Fundamentally based indices do have a higher turnover than capitalization weighted indices. However, the turnover is so low that its costs do not substantially affect returns. For example, the U.S. Fundamental Index 1000’s turnover ranges between 10 and 12 percent per annum versus 6% for an annually rebalanced capitalization-weighted index of the largest 1000 stocks. Furthermore, fundamentally based indices experience most of their turnover in large, liquid stocks while capitalization-weighted indices experience most of their turnover in small, illiquid stocks.

• Fundamentally based index funds have higher expense ratios than the traditional capitalization weighted index funds. For example, the Powershares fundamentally based ETFs have an expense ratio of 0.6% (the U.S. index ETF has an expense ratio of 0.39%) while the PIMCO Fundamental IndexPLUS TR Fund charges 1.14% in annual expenses. In comparison, the Vanguard 500 Index Fund charges 0.18% per annum.
  • Response: Fundamentally based ETFs do have higher expense ratios than capitalization-weighted ones but the 2 to 2.5% of additional returns per annum far outweigh the additional expenses incurred.