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October 2007

Fundamental Indexes: Investing More Intelligently

By: Jerry Moskowitz

In December of 1975, John Bogle, at Vanguard, established the First Index Investment Trust, a mutual fund that tracked the performance of the Standard & Poor’s 500 Common Stock Price Index. The fund was nicknamed ‘Bogle’s Folly’ by his critics and it was labelled ‘un-American’ for its passive investment strategy. Unconventional as this strategy was, the fund turned out to be a great success. Later renamed the ‘Vanguard 500,’ Bogle’s socalled ‘folly’ grew to become one of the two largest mutual funds of all time with more than $100 billion in assets under management. In the process, an entire industry was launched.

Some 30-odd years later, index investing is widely used by both institutional and individual investors as a tool for broad market exposure and is praised for its transparency, low fees, and low turnover. Tracking indexes offers investors a simple way to diversify their portfolios and research has also shown that indexes outperform active managers 75 per cent of the time. In the U.S. alone, index funds have more than $1 trillion in assets under management. They are used as benchmarks and in the construction of options, futures, exchange-traded funds, and structured notes.

Today, the landscape of indexing and index investing is quickly changing. Investors are finding that they have a choice as to what kind of indexes they want to track. In addition to traditional equity indexes as we think of them – large and small cap, industrial, U.S.-centric indexes – we are now seeing innovative indexes that give investors exposure to global markets, developing markets, the real estate industry, infrastructure, socially responsible investment, and more. Along with the proliferation of new sectors and asset classes, the very foundation of how indexes are calculated is beginning to shift as well.

fundamental indexes

Market-Capitalization Weighting

Until recently, almost all indexes were based on market-capitalization weightings, meaning that a company’s weight in an index is based on the price of its stock multiplied by the number of shares it has outstanding. Simply put, the more shares a company has outstanding and the higher its stock value, the greater its weight within the index. This method hinges on the Efficient Markets Hypothesis, which predicates that price equals true value and suggests that because markets are efficient, a cap-weighted index is an efficient equity investment.

The problem is that this hypothesis is not always true. In the open market, prices do not always reflect true value and they do move. Furthermore, as demonstrated by the technology bubble of 1998 to 2000, markets are sometimes emotionally driven rather than economically valued.

As a result of using the market-cap approach, over-valued stocks in an index become overweighted while under-valued stocks remain underweighted until market prices adjust themselves. Until this happens, investors are left overexposed to assets trading above their true fair value and underexposed to those trading below their true fair value. This phenomenon is called ‘return drag’ and can be particularly problematic during market bubbles.

Drawing another example from the recent technology bubble, the tech sector made up about 25 per cent of most market-cap weighted indexes at that time, up from about only eight per cent in 1995. The reason for the change in weighting was that during this period, the stock prices of technology companies were driven up by investor emotion and market noise, and the companies were grossly overvalued and over-weighted. When prices eventually adjusted themselves, the bubble burst and many investors suffered significant losses.

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