Passions run High on Indexing

It was quite a surprise for the debate over fundamental indexing vs. market-cap indexing to make it to the front page of the New York Times Business Section, but it has. In an article entitled, Passions run High on Indexing, by editor Joe Nocera, that appeared in the 17 May 2008 issue of the New York Times.

While few people can probably get excited about how indices weight their components, it matters to people in the ETF industry, because ETFs make money simply by having more assets under management. Any fund that has a secret formula for providing better returns may attract more investors.

The basic premise behind fundamental indexing, as proposed by Robert Arnott of Research Affiliates who has created the fundamental indices that underlie many Powershares products. His basic contention is that market cap weighting overweights the overweighted and underweights the underweighted, leading to underperformance in the long run.

His opponents claim that his system is not indexing. This is incorrect. It is simply an alternate form of weighting. Indexing is simply tying an investment to a particular index. The debate has gotten highly mathematical and arcane. Only time will tell who is right. However,
Arnott should not be counted out, as there is no doubt he is a very smart man -- he collaborates frequently with Peter Bernstein of Against the Gods: The Remarkable Story of Risk fame.

The other problem with many of his opponents' argument, is they see the S&P 500 as the “market.” This is not correct, as the S&P is not some unbiased measure of the “market” but 500 large cap stocks selected by the index committee at Standard & Poor’s according to criteria known only to themselves.