Joe Nocera finds himself enmeshed this week in a rather arcane fight within the world of index funds: the one between cap-weighted funds, on the one hand, and fundamentally-weighted funds, on the other. Nocera ultimately dodges the question – "they’ve both got a point," he says, but concludes by saying that fundamentally-weighted funds "ain’t index funds, and they shouldn’t be viewed as a replacement for index funds", which shows which way he’s leaning.
Brad DeLong seems to be leaning the same way, saying that fundamentally-weighted funds might have beaten the market in the past, and they might even beat the market in the future, but that ultimately they’re little more than a beat-the-market strategy, and all such strategies eventually stop working.
I think that both Nocera and DeLong are a little bit too unquestioning of the cap-weighted crew’s assumptions. Both of them look at a vaguely arbitrary entity known as "the market", and then ask how the fundamentally-weighted funds perform, using "the market" as a benchmark. As it happens, if you look backwards, the fundamentally-weighted funds have actually done very well by that benchmark. And if you look forwards – well, if you could do that with any accuracy, you’d have no need of mutual funds.
Where the cap-weighted crew have done magnificently well is that they’ve alighted on the S&P 500 as their chosen benchmark, and then decided that all investment decisions should be made with respect to it: they’re setting the terms of the debate. Now the S&P 500 is by no means a silly benchmark to use – for one thing, it significantly outperforms a genuine buy-and-hold strategy. But it is a bit silly to assume that the S&P is a sensible benchmark for all investors, at all times.
Nocera quotes Jack Bogle as saying “the market return is the market return,” and both Nocera and DeLong seem to accept this quite uncritically. But in reality it’s not nearly as simple as that. The market return, according to Bogle, is the S&P 500‘s return – and the S&P 500 is a tiny subset of the investable universe. There are European stocks and Japanese stocks and emerging-market stocks; there are all manner of fixed-income opportunities, both domestically and internationally; there’s commodities and currency funds and real estate and even, if you look hard enough, ways of investing in weird things like art and wine.
If you were going to take a subset of the investable universe as your benchmark, you wouldn’t necessarily alight upon the S&P 500. More likely, you’d take a risk-free subset instead – Treasury bills, say – and then ask yourself how much extra return you’d like, and how much risk you were willing to take in order to get that return. Jack Bogle could offer you this much risk and this much return by indexing the S&P 500; Robert Arnott could offer you that much risk and that much return by using his fundamentally-weighted index instead. You could then intelligently choose between them, and there’s a good chance that you’d choose Arnott over Bogle, because by all lights he’s offering a higher return at a lower risk.
Nocera’s good at pointing out the weakness of Bogle’s system:
Back in 1999, when Cisco Systems had, absurdly, the largest market capitalization in the world, it also had the biggest weighting in the Vanguard 500 Index Fund. And when the bubble burst, passive index investors lost money right alongside all those people who had tried to beat the market by diving into tech stocks. Not as much, perhaps, but they still lost money.
Anybody indexing the S&P 500 should be comfortable with precisely that investment strategy: putting more money into Cisco Systems than into any other company, not despite but rather because it’s trading at an absurd valuation. One could almost call it momentum investing, if one didn’t fear the wrath of Bogle for even hinting at such a thing.
Individual investors, when they make their investing decisions, have, if they’re smart, generally started with a top-down asset-allocation approach (this much in stocks, that much in bonds, maybe some commodities or REITs to round things out). Then, once they’ve decided how much money they want to invest in stocks, they’ve put that sum into an S&P 500 index fund, on the unquestioning assumption that that way they’ll get Bogle’s "market return".
But as the tech bubble taught us, all stocks are not alike, and the more value-focused stocks which form the bulk of the fundamentally-weighted funds are genuinely less risky than the S&P 500 as a whole, even when they underperform. For many investors a fundamentally-weighted fund might well suit their risk profile better than an S&P 500 index fund – or it might free up a bit more risk appetite to go exploring in places like emerging markets and commodities.
Buying any kind of index fund is simply buying a certain asset class, nothing more. S&P 500 index funds will give you exposure to one asset class; fundamentally-weighted index funds will give you exposure to a slightly different asset class. And I’m wary of people who will tell you that the former is better than the latter because it is the market. It’s not.