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Index controversy

From Canadian Business Online,

Index investing

Index controversy

Market-cap vs fundamental weights.

By Larry MacDonald

Larry MacDonald is a former economist who now manages his own portfolio and writes on investment topics. He is the author of several business books, including corporate biographies of Nortel and Bombardier. His column appears every second Thursday. Read Larry's Investment Ideas blog here. More stories by this author >>

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If you are an index investor, you may have wondered if it is better to use exchange-traded funds (ETFs) based on market-capitalization weights or ETFs based on non-cap weights, such as the fundamental factors of revenues, cash flow, dividends and book value. There has been a lively debate over which is best — and it could get livelier given recent developments in their performance.

First, a quick overview of main points in the debate:

Testing on stock-market data shows fundamental- and equal-weighted indexes outperformed cap-weighted indexes over past decades — see, for example, the comparisons in the "Market Cap, Equal Weight And Fundamental Indexing" by Rich White

Indexing pioneers John Bogle, Burton Malkiel and William Sharp dispute whether the outperformance will continue over future time periods for reasons summarized in my post, "Market-cap vs. fundamental indexes"

What I would like to focus on are recent developments in the performance of ETFs. They may shed new light on the debate.

Let’s begin with the widely accepted explanation for the historical underperformance of cap-weighted indexes. They put too much emphasis on overvalued stocks and too little on undervalued stocks. This may serve them well during the latter stages of bull markets but causes them to crash hard in bear markets — such that they end up underperforming non-cap counterparts over the full cycle.

But this scenario did not quite unfold during the recent bear market, which from market peak to trough went from late 2007 to early 2009. Over this period, market-cap ETFs fell by less than fundamental ETFs.

For example, at the mid-point of 2008 in the U.S. market, the market-cap iShares Russell 1000 Index Fund (NYSE: IWB) was down -19.7% while the fundamental PowerShares FTSE RAFI U.S. 1000 Fund (NYSE: PRF) was down -25.5%. And at the end of the first quarter of 2009, the IWB had dropped by -55.7% versus -60.7% for PRF. (A comparison between the Rydex S&P Equal Weight ETF (NYSE: RSP) and SPDR S&P 500 ETF (NYSE: SPY) during the bear market period revealed a pattern similar — albeit to a lesser extent — to the fundamental ETF and market-cap ETF comparison.)

What would seem to account for the relative performance, in large part, is that the fundamental ETF had a noticeably bigger weighting in hard-hit financial stocks. This weighting should come as no surprise as the fundamentals in the sector were quite strong before the financial crisis arrived.

All this begs the question: since the fundamental index did not jump ahead during the bear market when much of its long-run outperformance was expected to occur, will outperformance materialize in years ahead?

So far, the answer would seem to be yes: during the rally following March 2009, PRF rose at a faster rate. The explanation in large part would seem to be that financial stocks rebounded more vigorously than the market.

One does wonder, however, as the economic recovery progresses (presumably) and the bull market gains traction, if this early outperformance in PRF will hold up. One reason is that as the bull market gains more momentum, it begins to support cap-weighted ETFs more (for reasons provided above). A second reason pertains to financial stocks and whether or not they can continue to contribute at the same pace to the fundamental index.