Yesterday, many Fool writers made compelling arguments for individual exchange-traded funds (ETFs) and proposed that readers select the one they most prefer by selecting it as an "outperform" candidate in Motley Fool CAPS. As Brian Richards pointed out, there's a large wave of recent and pending ETF offerings currently sweeping the market. The prudent surfer dude, however, knows to look over his shoulder before jumping on a big wave, because the more choice offering may be what's coming next.
In an attempt to channel my inner Spicoli and look to the horizon, I can't help but notice that the future of investing may very well lie in fundamental indexing. The concept is based on a 2004 article titled Fundamental Indexation by Robert Arnott, Jason Hsu, and Philip Moore. The authors backtest the performance of indices in which companies are weighted by fundamental criteria rather than the customary market capitalization. The fundamentals examined were book value, cash flow, revenue, sales, dividends, and even employment. Indices were assembled that weight companies on the basis of these criteria, and all would have outperformed a market cap weighted index.
To oversimplify the rationale, consider the market to be efficient overall, but the companies that make up the market to be less so. At any time, companies may be overvalued or undervalued relative to their actual net worth. Total market capitalization is the ideal way to place a current value on the overall market, but an index thus assembled will contain too much of every "overvalued" company and too little of every "undervalued" company. Moving forward, assuming a company's true value becomes realized by the market, this capitalization bias will hinder returns. In fact, assigning weighting by just about any random criteria should reduce the exposure to the overvalued companies and increase exposure to the undervalued companies, purely by happenstance.
A number of investment vehicles, mostly ETFs, have been designed to take advantage of alternate company weighting in an index. The Rydex S&P Equal Weight Index
Research Affiliates, chaired by Robert Arnott, author of the aforementioned article, has an ETF offering as well (managed by PowerShares). The RAFI 1000 Index
With the floodgates now open on the methodology, investment offerings from the likes of WisdomTree and PowerShares have jumped on the fundamental indexing bandwagon. Wisdom Tree, under the guidance of professor and dividend guru Jeremy Siegel, launched 20 ETFs that weight according to dividend payout. These offerings include a few interesting ETFs like the WisdomTree Total Dividend Fund
In theory, market capitalization weighted indices do not have to rebalance, allowing them to carry the lowest of expense ratios. Nothing can sap a fund's performance faster than expenses. In fact, the ETF for the RAFI 1000 Index charges 0.60%, modest but substantially higher than the 0.10% charged by the popular market cap weighted S&P 500 Depository Receipt, SPDR
Make your voice heard by rating these ETFs in CAPS:
- Rydex S&P Equal Weight Index
- First Trust Nasdaq-100 Equal Weight Index
- RAFI U.S. 1000
- WisdomTree Total Dividend Fund
- WisdomTree Japan SmallCap Dividend Fund
For information and recommendation on funds, try a trial of Motley Fool Champion Funds free for 30 days.
Fool contributor Ralph Casale wonders whether the Spicoli reference dates him. He holds no financial position in any other firm mentioned, but does own Amvescap