FUNDAMENTALLY FLAWED
What goes around comes around. There are thousands of
investing options and investing strategies and one of Wall Street’s
tried-and-true tactics is to prey on investors who have grown bored with
routine and are in the market for something more exciting. The problem,
however, is that many of Wall Street’s "latest and greatest" ideas are
really just recycled concepts. They even, on occasion, offer things that
have worked for years, but that they’ve subtly wrapped in new packaging.
Investment thrill seekers are now being lured by
fundamental indexing, which was recently reintroduced to investors. What
forms the basis of the latest fundamental indexing pitch is that at any
given time, 50% of stocks are underpriced and 50% are overpriced. This
is in direct conflict with the efficient market hypothesis (EMH), which
says that any factor that could influence a stock will be very quickly
considered and reflected in its price.
The problem with EMH, it’s argued, is that if you are
using a traditional index fund that invests across the market, the
stocks that are overpriced will balance out those that are underpriced,
which translates to lower return for the investor.
The latest solution, courtesy of Rob Arnott, is to
take "fundamental" factors relating to a company’s size (things like
dividend payments, company sales, cash flow, revenue, etc.) and build
indexes around those factors. For instance, his RAFI 1000 index
considers gross revenue, equity book value, cash flow and dividends. If
companies meet certain thresholds in those four areas, they are included
in his fundamental index.
Fundamental indexing’s reintroduction has garnered
much attention and sparked debate among the passive investment
community, primarily because the new strategy’s method contains some
potential risks.
First, fundamental indexing can potentially weight
certain sectors in a manner much differently than the market as a whole.
The most recent commercial application is demonstrated by Wisdom Tree, a
fund company that jumped on the fundamental indexing bandwagon this past
summer and that focuses on just one factor: dividends. If dividends are
the sole consideration, what becomes of the thousands of stocks
representing companies that don’t pay dividends? They fall by the
wayside, leaving investors with a portfolio that has huge pieces missing
from the market pie chart.
In addition, by focusing on dividends (to continue
with this example), you end up heavily weighted in just a few
industries. As syndicated columnist Scott Burns pointed out in a
November column, Wisdom Tree’s Small Cap Dividend index ETF has 60% of
its holdings in financial stocks. Another, the Wisdom Tree Large Cap
Dividend, has 30% in financial stocks. The problem is that financial
stocks make up only 22% of the market. Again, accurate market
representation is no longer there.
A second issue is that fundamental indexing could
potentially encourage more transactions in a portfolio than should be
reflected in a passive management strategy. When this occurs, it results
not only in higher expenses in the form of management fees and turnover
costs, but could also result in short-term capital gains that are taxed
at ordinary income tax rates when the portfolio is adjusted.
Fundamentally weighted companies must continually be rebalanced when
changes occur in the market. For example, in a dividend index, if a
company’s dividend doubles, the portfolio would need to buy more of that
stock (and sell others) to double the weight of the stock. Or, if a
stock doubles in price, but dividends don’t change, some of that stock
must be sold to bring it back into balance. The transaction fees and
other costs quickly begin adding up.
Finally, the "new and improved" fundamental indexes
have no track record. While they tout higher return, it is based on
back-tested models rather than any long-term historical data.
John Bogle and Burton Malkiel pointed out in a June
editorial they placed in The Wall Street Journal that many "new
paradigms" have come and gone throughout the years. Before you get
restless and begin seeking out more "cutting-edge" or innovative ways to
invest, consider that the latest form of fundamental indexing may likely
fall out of favor in much the same way trends such as concept stocks,
option-income funds and high-tech stocks did.
Markets are efficient. No one investor is smarter than
the market and no new twist on scientific, proven success will change
that.
