Fundamental Indexing: The Real Deal?

Summarizing, fundamental indexing's detractors say it's just a slickly packaged version of value- and small-cap-stock investing. Investors pay more for the packing than they need to and these indexes haven't been around long enough to provide certainty of return — in spite of all the back-testing Arnott and others have done.

For the DefenseAs the president of RevenueShares Investor Services of Paoli, Pa., Sean O'Hara is uniquely qualified to discuss the reasons to like fundamental indexing and, more particularly, the ETFs his company offers.

As the company's name suggests, O'Hara's offerings are weighted based upon revenues — not earnings, dividends or book value — just revenues. "As I see it, you've got market-cap-weighted indexes at one extreme; they've been the norm forever, and they're primarily a price game. For nine basis points, Barclays and State Street will make these available to you. On the other end, you've got fundamental indexes and people like PowerShares and WisdomTree creating their own indexes of 300 or 500 or 1,000 stocks — a competitive alternative to traditional capitalization weighting. Where we fit is in between the two. We don't create our own indexes. We'll take the S&P 500 and apply a revenue-weighting factor."

Why just revenues? O'Hara explains: "First, according to our tests, revenue [as the weighting mechanism] produces the highest return over time. Second, if I want to use a known index [like the S&P 500], I have to use a weighting factor that all members of the index have in common. It couldn't be dividends, for example, and earnings are similarly problematic. Finally, revenue isn't a number that changes often or can be manipulated easily. Everything else can change on a whim, like dividends, but not revenue."

And to those who say fundamental index expenses are so high because of the marketing dollars companies must spend to explain and promote these products, O'Hara says: "We don't spend money on national advertising. We believe in the salesperson's model, so we have people across the country who call on financial advisors and provide an education as to how these indexes work."

And he's getting through to some. Roy Komack of Family Financial Architects in Natick, Mass., says: "I believe the 'productizing' and marketing of fundamental indexation is brilliant. To me, it's just common sense that securities should be weighted by their economic footprint [e.g., revenues] rather than by what public sentiment 'believes' they ought to be worth [i.e., market price]. After all, public sentiment is what creates Extraordinary Popular Delusions and the Madness of Crowds [a reference to the book by Charles Mackay]."

Norm Boone, a veteran advisor and head of Mosaic Financial Partners in San Francisco, agrees: "I happen to think the concept of fundamental indexing is brilliant. There's nothing terribly new about it, as such, but the way Arnott has put it together — developing four different indices based on different fundamental factors and combining them — is unique and new. The combination moderates the problems of each and becomes a more rational way to determine what belongs in your index than just going on the basis of market-cap."

Estimates are that $30 billion has made its way into fundamental index investments. Judging from the above comments, more dollars may have come directly from individual investors than from financial advisors, but that may change with time. Just as mutual funds are a more convenient way to invest in common stocks than is direct stock investing, fundamental indexing may come to be seen as a similarly convenient alternative to value and small-cap funds. And the costs … well, let's just say cap-weight indexes were once a lot more expensive than they are now.

—

David J. Drucker, CFP, is president of Drucker Knowledge Systems; see www.DavidDrucker.com.