Fundamental Indexing

On a trial basis, I've been trying to roll some of my non-retirement savings out of mutual funds and into ETFs. Let's say I've been taking whatever I'm reading in my finance books a tad too seriously! All skepticism aside, I don't like having to shell out the expense ratio, especially when you read that many mutual funds don't even beat market returns. See excerpt from Investopedia:

The Journal of Finance (Mar 1997) reports a comprehensive study by Mark Carhart on mutual funds over the period from 1962 to 1993. He states that "by 1993 fully one-third of all mutual funds had disappeared." Furthermore, in 1997 the Wall Street Journal reported that during 1982-1992 mutual funds reported average returns of 18.1%, but after calculating in survivorship bias, the report found that this return was whittled down to 16.3%, lower than the 17.5% return on the S&P 500 during the same period. In other words, when we take survivorship bias into account, the average mutual fund underperforms the market.

All that said, I probably will stick with funds like MINDX and MAPTX when it comes to investing in foreign/emerging markets.

With low expense ratios, ETFs are an attractive choice. But which ETF? Armed with new found knowledge about fundamental indexing (from Chapter 4 of BMA as well as Prof Percival's lecture), I did a bit of poking around.

In a capitalization weighted index, the weight associated with a particular stock is based on its market cap. In a fundamental index, that weight is based on some fundamental metric. Dividends appear to be a particularly good metric if you believe companies need to stop screwing around holding large amounts of cash, with no good projects to invest in.

See Prof Seigel's article on WSJ for a detailed description of the fundamental weighted indexes as the "next wave of investing".

The Fama/French world emphasizes low P-E and small cap stocks. Bogle et al in another WSJ article cite a few reasons about why you probably shouldn't be too eager to jump on the fundamental indexing bandwagon. They cite

1. Potentially high management fees for fundamental indexed funds
2. Equivalency of fundamental indexing to picking low P-E and small cap stocks (which Fama/French have shown produces outsized returns)
3. Turnover - say when a manager increases dividends, you're going to have to buy more of that stock. This is not an issue especially if you are investing your retirement savings.
   
4. Fundamental indexes constructed out of dividends as the metric may not be tax efficient. (Long-term capital appreciation enjoys favorable taxation compared to short-term gains such as dividends.)
   

Do your own diligence, but I'm trying out a couple of fundamental indexed funds from WisdomTree. I'm going with Dividend-Weighted ETFs instead of Earnings-Weighted ETFs.