'Godfather' of Fundamental Indexing Faces Challenge

A year ago this week, when WisdomTree Investments (WSDT Quote) launched its first 20 exchange-traded funds, it threw down the gauntlet in the rarified world of indexing.

At the time, it was the largest number of ETFs tracking indices based on fundamental criteria -- primarily dividends -- rather than stock prices.

It was also a challenge to Rob Arnott, the godfather of fundamental indexing. Arnott's investment firm, Research Affiliates, had licensed the first ETF based on a fundamental index a year earlier and filed a patent application for all indices based on fundamentals.

But WisdomTree didn't seek Arnott's blessing for its new products. In essence, the firm was saying that fundamentally weighted indexing isn't the property of Research Affiliates but of the entire world.

Typical indices weight companies according to their stock market valuation, also known as market capitalization. This value is calculated by multiplying the total number of outstanding shares by the stock's price. The criteria give a greater weighting to large companies and higher-priced stocks over small companies and lower-priced stocks. It's the basis for the S&P 500 and most other market benchmarks.

The theory behind fundamental indexing is that market-cap-weighted indices were overweighted with overpriced stocks, while fundamentally-weighted indices captured better returns with lower volatility.

WisdomTree promoted the new ETFs with a splashy marketing campaign, including newspaper and TV ads featuring endorsements from two of its famous backers, legendary hedge-fund manager Michael Steinhardt and Wharton finance professor Jeremy Siegel. But the highlight of the marketing blitz was an opinion piece on The Wall Street Journal's op-ed page in which Siegel lobbed a grenade at the "efficient-market theory," the philosophical foundation for the market-cap indices.