The Other Half of the Indexing Debate
By Ron DeLegge, Editor
August 11, 2008

SAN DIEGO (ETFguide.com) - Over the past few years, investors have been entertained by the mudslinging between two distinct camps of index investing: Traditional indexers vs. fundamental indexers.

The first generation of exchange-traded funds (ETFs) mostly followed market cap weighted indexes.

Then, in 2003 everything changed.

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It was that year, when InvescoPowerShares introduced funds following quantitatively driven indexes designed by the American Stock Exchange (Amex) known as “Intellidexes.” From that moment forward, the number of ETFs following alternative weighting methods took off.  

Traditionalists generally favor market capitalization weighted indexes. By design, securities with the highest market cap have a greater impact on the movement of the index. In this indexing camp are individuals like Burton Malkiel, Professor at Princeton University and John Bogle, founder of the Vanguard Group. Both men on numerous occasions have made it a point to defend market cap weighted indexes and to attack the back tested results of fundamental indexes. 

In the other corner, are the fundamental indexers that argue they’ve identified a better way to construct indexes.  By design, securities with the best fundamentals (high dividends, low valuation, etc.) receive a higher index weighting. Rob Arnott of Research Affiliates and Jeremy Siegel, Professor at The Wharton School of the University of Pennsylvania have been advocates of fundamentally designed indexes. Each has taken their shots at highlighting the perceived flaws of market weighted indexes.

Interestingly, a disproportionate amount of the debate has focused only on one aspect of index construction and management: how securities are being weighted. What about the other half of the debate?

Largely ignored in all of the mudslinging between indexing giants is how securities are being selected within indexes. Is it a passive, screened, or a quantitative approach?

Listening to all the talking heads, one would be hard pressed to know anything but index weightings mattered.

Adding to the confusion is the fact that many ETF investors hear the word “index” and erroneously associate such investing as “passive”, when the opposite may actually be true. 

What can help investors to see the light?

ETFguide.com’s Index Strategy Box™ tool looks at the indexing debate from a full and unobstructed perspective.

This cutting edge financial tool organizes both ETFs and exchange-traded notes (ETNs) by two of their most meaningful dimensions: First, how underlying indexes select securities and second, how they weight them. 

Now we can analyze 100 percent of the indexing debate, instead of just 50 percent.