Smart Money
By the Numbers
by Jack Hough
Published January 31, 2011

The Journal of Indexes gives academic treatment to bland investments, and so might not seem a likely source of hot controversy. The latest issue, however, is packed with it–and has greatly annoyed mutual fund titan Vanguard. A report therein gives new support for the claim that most index investors are unknowingly missing out on a large portion of the returns that their passive approach ought to provide…

“We are passionately opposed to the theory, research and methodology of indexes based on accounting measures,” says Francis Kinniry, a principal in the Vanguard Investment Strategy Group. He calls Fundamental Indexing rules-based management, not indexing. “Indexing by definition is market cap weighted. A market cap reflects consensus dollars at work and any deviation to it is active management…”

(Rob) Arnott (Founder of Research Associates) announces his first five years o(f) real-world performance. His U.S. portfolio beat its cap-weighted competitor by 2.3 percentage points a year since November 2005. That’s close to the 2.2 percentage points of simulated outperformance Arnott claimed in an April 2005 article in Financial Analysts Journal.

Critics of Arnott’s Fundamental Indexing approach have long argued that it’s a disguised form of value investing because it tends to overweight companies with low prices relative to their dividends, sales and earnings.

“That doesn’t bother me at all,” says Rob Arnott, founder of Research Affiliates. “It’s semantics. We weight companies by their economic footprint. Look up ‘index’ in the Oxford dictionary and you won’t find anything about cap weighting.”

http://www.smartmoney.com/investing/mutual-funds/is-your-index-fund-broken-1296258353915/#

Of course, one can be more of a value investor by investing in a broad index based on value-investing fundamentals rather than one based on the largest companies in the market (e.g. S&P 500), but one still would not be a value investor. It is more than semantics, but kudos to Arnott for beating the market by a little with a watered-down, value-ish product, just as we value investors could have predicted he would. Simple value investing tends to beat the market by a little and sophisticated value investing tends to beat it by a lot.

And, don’t get me started on so-called “value” indexes that are made up of the cheapest half of a popular index, such as the 250 companies in the S&P 500 Value Index. No self-respecting value investor would ever think that half of the companies in a broad index could be values.

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