Malkiel, Bogle Argue Against Non-Market Capitalization Weighted ETFs

I found this little nugget from June 2006 from a link I saw (not a very interesting read) on Canadian Capitalist’s blog. It’s an article called “Turn on a Paradigm?” (very interesting read) and it was written by Burton Malkiel (author of a Random Walk Down Wall Street) and John C. Bogle (Founder of The Vanguard Group). It attacks the idea that fundamental-weighted indexes can beat the market capitalization weighted indexes. Or, at least, challenges the idea that the former can beat the latter with the same risk. (I thought that’s what they were getting at near the end when they mentioned that fundamental-weighted indexes often hold more small caps which have performed well lately, albeit at higher risk. Although they seem to argue more along the lines that due to the reversion to the mean principle, those equities that recently did well since 2000 will not be doing necessarily so well in the future.)

It’s a great little introduction to the concepts in A Random Walk Down Wall Street (a book that I am reading right now). In case some of you are not interested enough to read it (the article, not the book), I will quote my favourite two paragraphs for you here:

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. We can not live in Garrison Keillor’s
Lake Wobegon, where all the children are above average. For every investor who outperforms the market, there must be another investor who underperforms. Beating the
market, in principle, must be a zero-sum game.

But only before the deduction of investment management costs. In practice, investors as a group will fail to earn the market return after these costs, and as a group, they will fall far short of the low-expense index funds. 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.

Wow! I can’t wait to get into the meat of Malkiel’s book. I’ll give them the last word — “Intelligent investors should approach with extreme caution any claim that a ‘new paradigm’ is here to stay.”

2 thoughts on “Malkiel, Bogle Argue Against Non-Market Capitalization Weighted ETFs”

  1. Dave: John Bogle’s new book Little Book of Common Sense Investing devotes an entire chapter to the drawbacks of the new fundamental indices. His argument that there is logic behind the success of traditional indexing but the reasons for why fundamental factors were mispriced by the market in the past is unknown and unexplained. Investors are going to get future returns, not the past, and who knows if the same factors will remain mispriced in the future. What if they don’t? Not a wager I am willing to make.

  2. The other thing I should mention is that I no longer think market-cap weighted indexes are as evil as I once thought. I used to not like them because they would have large holdings of temporarily overpriced stocks, like the way Nortel affected the TSE in Canada and all the other tech stocks that influenced the S&P 500 in the US. If you are buying the index during a bull cycle (or a bubble rather, like in 1999-2000, for example) you’re bound to be affected (no matter what you buy) but for long term investors this is no big deal.

    CC: “investors are going to get future returns, not the past, and who knows if the same factors will remain mispriced in the future”

    I totally agree, and the hoopla over fundamental indexes outperforming passive indexes just sounds like classic performance-chasing to me. Bound to fail.

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