Every ETF follows either an established index or, with increasing frequency, a newfangled one. In fact, of the 482 publicly traded U.S. equity ETFs, 39 percent launched in 2007. Some newer ETFs are the beneficiaries of hypothetical back-tested results, and thus are being sold on the basis of these hypothetical returns. If these newbie indices could talk, they might say: "Look at how well you would have done, if I knew then what I know now." But as increasing numbers of investors and advisors are enticed by the allure of these new strategies, they would do well to pay less attention to the back-tested results, and focus more on the real or post-hypothetical performance.
Obviously, when you create a track record for a commercial product, you want the best results. With a goal of best returns, back-testing can benefit from pattern recognition, portfolio exclusion, survivorship bias, and other metrics that refine the historical portfolio allocation to achieve the desired outcome. For example, because missing the tech bubble is a great way to bolster back-tested returns, an ETF might exclude it when defining its index. The resulting formula would resemble a successful portfolio strategy, but it would not be a realistic, traditional market barometer. In contrast to the complicated process that defines many indices created for ETFs in this manner, traditional indices have simple rules with a controlling authority--called the index committee--acting as a gatekeeper. There is no agenda to create results.
Among the most attention grabbing of the new ETFs are fundamentally weighted products, whose creators tout the back-tested results of their newfangled portfolio strategies. Two of the most prominent examples are the Powershares FTSE/RAFI 1000 ETF, launched on Dec. 19, 2005, and the WisdomTree dividend-weighted ETFs, launched June 16, 2006.
According to finance professor (and WisdomTree Senior Investment Strategy Advisor) Jeremy Seigel, "Capitalization-weighted indices are no longer the best ones for investors. Fundamentally weighted indices will give you superior risk and return characteristics."
Meanwhile, Robert Arnott of Research Affiliates, the creator of the FTSE/RAFI 1000, has become synonymous with fundamental indexing. In fact, Research Affiliates has registered the term for trademarking. At the 10th annual Super Bowl of Indexing on December 5, 2005, Arnott received an award for the best index-related research paper; at the same time, his FTSE/RAFI Fundamental Index series won the award for most innovative benchmark index.
In a February 2007 article in Bloomberg Markets, Arnott says, "It's worth rebuilding the [S&P 500] index from the ground up." His Fundamental Indexes weight net worth, sales, earnings, and dividends. Given the success of value and small cap stocks versus the S&P 500 for the period he back-tested, it is not surprising that the weightings and variables Arnott chose produced fabulous hypothetical returns. The portfolio his FTSE/RAFI 1000 produces has a value bias and more small-cap companies than the S&P 500. Arnott contends that his indices do not capture a "pricing error" inherent in market capitalization-weighted indices (the pre-mentioned flaw).
In "An Overwrought Orthodoxy," a December 2006 article Arnott wrote for Institutional Investor, he closes with the following quote: "With Fundamental Indexes, we eliminate the disruptive effect of investor sentiment on the price of stocks--and thereby on their market caps. No longer must investors suffer a performance drag by settling for an index that inherently overweights every overvalued company and underweights every undervalued one. With due respect to the pioneers in finance theory and the cap-weighted indexers, there is a better way."
Taking a different tack are finance professors Eugene Fama of the University of Chicago Graduate School of Business and Kenneth R. French of Dartmouth College's Tuck School of Business, who developed the Capital Asset Pricing Model with their 1992 paper, "The Cross-Section of Expected Stock Returns" (Journal of Finance, June 1992). Their resulting Three Factor Model, as it is commonly known, incorporated the value versus growth and small-cap versus large-cap effects into the understanding of stock market performance. Fama and French contend that indexed portfolios that exhibit a value and small company bias could generate higher returns over a long period of time.
It is not surprising that Fama and French take issue with the marketing of fundamentally weighted indexes. In a March/April 2007 Journal of Indexes interview, titled, "Nouveau indexes, noise and the nonsense of active management," Fama proclaimed that "[fundamentally-weighted indexes] are a triumph of marketing and not new ideas. It's a repackaging of old ideas."
The views of Fama and French on fundamentally-weighted indices are similar to those of Vanguard founder John Bogle and Princeton Finance Professor Burton Malkiel. In published commentary from the June 27, 2006 Wall Street Journal titled, "Turn on a Paradigm?" Bogle and Malkiel wrote: "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... Intelligent investors should approach with extreme caution any claim that a 'new paradigm' is here to stay. That's not the way the financial markets work."
With two full calendar years of performance, the Powershares FTSE/RAFI 1000 has the longest track record of the fundamentally-weighted ETFs. When compared to its benchmark--the S&P 500 Index--it beat it by 3.07 percent in 2006. In 2007, it lost by 3.26. During 2007, value stocks lost to growth stocks, and small caps lost to large caps: compared to the S&P 500, the Russell 2000 Value lost by 15.27 percent and the Russell 1000 Value trailed by 5.32 percent. Given the portfolio held by the FTSE/RFAI 1000, the results are not surprising. Where is the alpha implied by Arnott's fundamentally weighted indexing strategy or, "better way?" WisdomTree has only one full calendar year of performance, and posted similarly disappointing results in 2007.
Psychologist/philosopher William James once said: "The art of being wise is in the art of knowing what to overlook." Clearly, the work of Fama and French showed the advantages of value over growth investing long before today's fundamentally weighted index funds were created. In 2007, when the six-year bull run was over for value and small-cap stocks, no alpha was produced by the fundamentally weighted indexes.
What Do I Know?
In 1998, I finished building a fundamentally weighted indexing portfolio strategy which was patented in 2006. In 1999, I introduced the Industry Leaders Fund (ticker ILFIX) which is based on this strategy. I was uncomfortable with marketing based on back-tested results, which preceded and were as good as other fundamentally weighted indices. Now, although I produced average annual alpha of 2.3 percent above my benchmark--also the S&P 500--I do not believe that I have found the "better way." Rather, I attribute my success to a sound investment strategy built on fundamentals and research from many esteemed investment professionals who came before me.
Gerald P. Sullivan is President and CEO of the Industry Leaders Fund, www.ILFweb.com.
