The Ignorant Investor

The New York Times business section does a short rundown on the current battle between Jeremy Siegel, professor of finance and director of WisdomTree, a company offering "fundamental indexing" products, and Vanguard's Jack Bogle, creater of the traditional S&P 500 cap-weighted index fund:

According to Mr. Siegel, there is a “revolution” under way, a “new paradigm” in which the traditional indexes like the S.& P. 500 will make way for fundamental indexing, which constructs indexes based on measures like companies that pay dividends, rather than just a company’s size. . .

. . Mr. Siegel says the central problem with traditional index funds, which are weighted by market capitalization, is that they overweight overvalued stocks and underweight undervalued stocks. Historically, value stocks outperform growth stocks, so an index should be constructed to invest in the cheaper value stocks rather than the expensive growth stocks.

“We should be shifting to another paradigm to look at how markets work,” Mr. Siegel said in an interview. “I don’t think the price of a stock is always in line with fundamentals. I think there are a lot of factors, which helps to explain a lot of what we see in the capital markets.”

. . . Mr. Siegel says that the market has a lot of “noise” in it and that prices are not the best measure of true underlying value, making market-cap weighting inefficient. A rise in a stock’s price may not reflect a change in fundamental value, but a lot of noise in the markets.

Bogle disagrees, saying that Siegel's approach is yet another "new paradigm" designed to outguess the market on the direction of security prices, one that is likely to fail just like the others.

What it comes down to is this: with the S&P 500 fund (or even better, the total market funds based on the Wilshire 5000), you get the benefit of all the collective wisdom of all the very smart people playing the market. Sometimes they're wrong when the value stocks, and sometimes they're right. But history indicates that you generally do better with this collective analysis than you do by following any particular manager or formula.

The fundamental indexes will rise or fall based on the wisdom of following the criteria they select. For Siegel, it's dividend paying companies. For others, it's a mix of P/E ratios, book values, price-to-cash flow, etc. I don't see this as much different than active management, since active "value" managers tend to use the same tools in their stock selections. So fundamental indexing seems like just another form of active management, albeit one that is cheaper and subject to less turnover than the typical fund.

Another alternative that's in the news is the so-called equally weighted S&P index fund represented by RSP. It's based on a version of the S&P 500 that gives each component the same weighting rather than weighing the stock by the size of their capitalization. Smaller issues end up contibuting more to returns in an equally weighted index than in the traditional 500 fund, in which the 100 stocks with the largest caps typically account for about 70% of returns. Over the past few years RSP has outdone the S&P 500 by a few points a year, basically because smaller issuers have been in a bull market as large caps have lagged. But note: when the worm turns and big caps lead, the S&P will outperform.

Over the very long term, RSP's managers say, stressing the smaller stocks lead to better returns if history is any guide. But this depends on at what point in the small cap/big cap bull market cycles you enter the market, and when you start to pull out your money. So if it's something that interests you, you can always buy both and split the difference.