Market Indexing

Fundamental indexing, an idea promulgated by Rob Arnott and his firm, caused quite a stir when it was introduced in 2004 with many questioning the whole idea. It has since given rise to a number of ETFs. The original is PRF, an ETF launched in December 2005. According to PowerShares' site, they are benchmarking PRF against the Russell 1000. Powershares followed on this product with 5 more, covering the developed markets ex-US (PXF), Asia Pacific ex-Japan (PAF), emerging markets (PXH), developed ex-US small cap (PDN), and US small-mid cap (PRFZ).

ProShares has its a RAFI long-short ETF under symbol RALS (inception December 2010). Russell collaborated with Research Affiliates to create 23 benchmark indices. WisdomTree has a whole bevy of products (23 of them) most of which weight by dividends and some of which weight by earnings (distinct from Arnott's methodology). The earnings weight ETFs have currently only attracted < 130M assets under management. The US dividend ones are generally doing better with some gaining 1B AUM. State Street has a SPDR Barclays Capital Issuer Scored Corporate Bond ETF (CBND) launched in April 2011 which allocates based on return on assets, interest coverage, and current ratio.

At least part of the controversy with fundamental indexing has to do with expansive definition of fundamentals. In practice, it seems to include everything outside of market capitalization and share price. Numbers such as employee headcount, revenues, income, and assets come with their advantages and disadvantages, but, in the end, they do reflect at least some aspect of a company's size. In contrast, some have included dividends as an additional measure. Portfolio construction by dividends and dividend growth certainly preceded fundamental indexing by a long time. iShares' DVY started trading since 2003. There were probably many dividend-focused mutual funds before that. For example, Vanguard's Dividend Growth Mutual Fund (VDIGX) started in 1992. None of these claimed to be indexing the whole market. Considering that dividend payers make up < 80% of the S&P 500, it would not make sense to say that dividend payers represent the whole.

Some articles on fundamental indexing

• ETF Database's interview with Rob Arnott
• An article that acknowledges PRF's outperformance but argues that simple rebalancing would work for most people.
• An introduction to a SPDR ETF that fundamentally indexes corporate bonds
• An early critique of fundamental indexing
• A critique from 2005 arguing that fundamental indexing is not indexing at all but an investment strategy