Blogs & Comment

Market-cap vs. fundamental indexes

I have recently seen some posts recommending fundamental weighting over market-cap weighting in exchange-traded funds (ETFs).The authors may well be right: weights based on sales, free-cash flow, dividends and/or book value do not overemphasize overvalued stocks andshould lead to better performance over the long run. Indeed, backtesting shows fundamental indexes have outperformed market-cap indexes in the past.
What makes me hesitate is the opposition from indexing heavyweights John Bogle, Burton Malkiel and William Sharp. See, for example, Chapter 14, Index funds that promise to beat the market, in Bogles book, The Little Book of Common Sense Investing.
It is noted therein that fundamental indexes are said to perform better because they tilt toward value and small-cap stocks, segments that studies have shown historically command a premium over the general market. But why should this premium persist into the future? History shows that whenever opportunities arise to capture excess profits in the stock market, they attract an influx of investors who bid up prices until the opportunity is arbitraged away.
Moreover, fundamental indexes typically have higher annual expense ratios, greater turnover in portfolios and more distributions of taxable capital gains. Even if the modest margins claimed in the past were to repeat which I believe is highly unlikely these backtested hypothetical returns would be significantly eroded, if not totally erased, by those costs, writes Bogle.