Bogle and Malkiel Discuss Fundamental Indexing

Today's Wall Street Journal has a great op-ed piece by John Bogle (former head of Vanguard funds) and Burton Malkiel (Princeton finance Professor and author of "A Random Walk Down Wall Street"). In it, they do a pretty thorough job of discussing some of the potential problems with "fundamental indexing."

For those unaware with the term, here's a little background: Indexes (and index funds) can be weighted many ways - by market capitalization (i.e. a stock with twice the market cap would have twice the weight in the portfolio), equally (all stocks have equal weight) or by some other factor. The S&P 500, for instance, is a market-cap weighted index.

Proponents of "fundamental indexing" contend that portfolios that are indexed by some fundamental factor could significantly outperform traditional cap-weighted index. For example, Eugene Fama and Kenneth French contends that portfolios of small-cap and high price-book firms would be superior, Robert Arnott proposes indexing on factors such as sales or book values, and Jeremy Siegel suggests portfolio weighting on the basis of dividends.

Bogle and Malkiel provide several good reasons why fundamental indexing is unlikely to outperform cap-weighted indexing:

• Higher annual operating expenses
  
• Higher management fees
• Higher portfolio turnover
• Higher tax burden tax
  

Read the whole thing here (note: online subscription required)

Updated 6/29: To place things in a better context (and give the other side's arguments in their own words), I thought I'd link to the op-ed piece that Jeremy Siegel wrote in the WJS on 6/14, titled "The Noisy Market Hypothesis". You can read it here (as before, online subscription required):