Malkiel and Bogle Cheer for Index Funds

Malkiel and Bogle cheer for index funds:

WSJ.com - Turn on a Paradigm?: By JOHN C. BOGLE and BURTON G. MALKIEL: As index funds gain an increasing share of the portfolios of mutual funds, institutional equity and bond funds, academics and practitioners are hotly debating how these portfolios should be composed. Capitalization-weighted indexing, until now the dominant approach, has come under fire for overweighting portfolios with (temporarily) overvalued stocks and underweighting them with undervalued ones.

Eugene Fama and Kenneth French have suggested that higher returns can be generated by indexed portfolios of stocks with small capitalizations and low price-to-book-value ratios. Robert Arnott has argued that a better method for indexing is to weight the stocks in the index not by their total capitalization, but rather by certain "fundamental" factors such as sales, earnings or book values. Jeremy Siegel has proposed that the "fundamental factor" should be the dividends that companies pay. These analysts have all argued that fundamentally weighted indexes represent the "new paradigm" for index-fund investing.

Are they correct? We think not. There is no doubt that fundamentally weighted indexes have outperformed capitalization-weighted indexes during the past six years, which witnessed the collapse of the "new economy" bubble and partial recovery. But we need to be cautious before accepting any "new paradigm" that implicitly suggests that the "old paradigm" -- reflected in more than $3 trillion of capitalization-weighted index investment funds -- is in error....

First let us put to rest the canard that the remarkable success of traditional market-weighted indexing rests on the notion that markets must be efficient. Even if our stock markets were inefficient, capitalization-weighted indexing would still be -- must be -- an optimal investment strategy. All the stocks in the market must be held by someone. Thus, investors as a whole must earn the market return when that return is measured by a capitalization-weighted total stock market index.... Beating the market, in principle, must be a zero-sum game.... For the typical actively managed equity mutual fund, annual operating expense ratios are well over 100 basis points (one percentage point). Add in the hidden costs of portfolio turnover and sales loads, where applicable, and effective annual costs are undoubtedly considerably higher, perhaps as much as 200 to 250 basis points. In total, simply because the average actively managed fund must underperform the capitalization-weighted market as a whole by the amount of financial intermediation costs that are deducted from the gross return achieved, active investing must be, and is, a loser's game....

Purveyors of fundamentally weighted indexes also tend to charge management fees well above the typical index fund....

Every method of fundamental indexing tends to overweight smaller capitalization stocks and so-called value stocks. Consider the rationale for fundamental indexing. If, during some speculative bubble, money pours into high-tech stocks, their weight in a cap-weighted index increases. Since their price rise generally exceeds any fundamental measures of value, such as dividends or book value, such stocks will tend to have increased cap weights versus fundamental weights.

Consequently, fundamental weighting will tend to produce portfolios that give more weight to companies that are smaller in size (capitalization) and that have "value" characteristics such as low prices relative to earnings, dividends, sales and book values. Fundamental indexing will tend to do well in periods when small-cap stocks and "value" stocks tend to outperform. Thus it is not surprising that most of the long-term excess return attributed to fundamentally weighted portfolios was achieved between 2000 and 2005 alone, one of the best periods in history for the relative returns of dividend-paying stocks, "value" stocks and small-cap stocks....

While we have witnessed many "new paradigms" over the years, none have persisted. The "concept" stocks of the Go-Go years in the 1960s came, and went. So did the "Nifty Fifty" era that soon followed. The "January Effect" of small-cap superiority came, and went. Option-income funds and "Government Plus" funds came, and went. High-tech stocks and "new economy" funds came as well, and the survivors remain far below their peaks. Intelligent investors should approach with extreme caution any claim that a "new paradigm" is here to stay. That's not the way financial markets work.

Dividends are, in a sense, a function of firm managers' beliefs about the sustainable payout that the firm can maintain. Capitalize the sustainable payout and you have a measure of the firm's fundamental value. Surely Bogle and Malkiel don't wish to argue that the market's estimate of fundamental value should have a 100% weight and the firm managers' estimate a 0% weight in choosing a porfolio, do they?