360 Degrees of WisdomTree

To me, John Bogle and Burton Malkiel recently wrote the investment industry's rough equivalent in a Wall Street Journal op-ed. As the founder of the Vanguard Group, Bogle's legacy in this industry is no doubt secure, but his and Malkiel's central assertion in that essay -- that today's cap-weighted indices cannot be improved upon -- gives that uncomfortable feeling of watching the once-great football coach whom the game has quietly passed by.

My broad take on ETFs is that they remain in their infancy.

Sure, SPDRs (SPY) have traded since 1993, but DIAMONDS (DIA) didn't make their debut until 1998 and the Nasdaq 100 Trust (QQQQ) not until a year later. It was only then that the light bulb turned on in heads on Wall Street: Why don't we create ETFs based on narrower indices? Readers might be surprised to recall, for example, that the popular Oil Service HOLDRs(OIH) didn't begin trading until 2001.

And most of today's ETFs are younger still.

In a recent article, I made the case that actively managed ETFs are likely in our future. For now, though, they're still strictly index-based, so doesn't it make sense that our industry would re-examine exactly how indices are built in the first place and whether that process can be improved upon?

Why would one assume that no advances can be made? And if improvements are possible, why doesn't fundamental indexation mark a logical place to start? Certainly, the impressive track records of the people involved at WisdomTree -- including Steinhardt, Siegel and Frank Salerno -- suggest they should at least be given the benefit of the doubt. And countless academic studies that prove the importance of dividends in a portfolio's total return suggest WisdomTree's dividend-based focus makes terrific sense.

Bogle and Malkiel claim that ETFs based on fundamental indexation will result in higher expense ratios. WisdomTree's ETF products have fees ranging from 0.28% to 0.58%; the difference with cap-weighted ETFs is so small as to be inconsequential, particularly if WisdomTree has indeed built a better mousetrap.

Their warning that trading fees will be higher is certainly a red herring, as decimal pricing and lower trading costs have completely diminished such "portfolio drag" from what it used to be -- just ask any institutional broker on Wall Street to compare what he's getting paid per trade today versus a decade ago.

Bogle and Malkiel also rail about higher portfolio turnover and the higher taxes that may result. It's true that WisdomTree's large-cap products can be expected to have slightly higher turnover (though it's not at all certain this will translate into higher capital gains), but its small-cap products likely won't because the indices they're benchmarked against, such as the Russell 2000, already have high turnover themselves.

Obviously, heart surgery has improved since 1896, and it will continue to evolve. Likewise, we're likely at the beginning, not the end, of improvements in index creation and exchange-traded funds.

If Bogle's article indicates that his firm intends to stick only to its traditional cap-weighted indices and ETFs, Vanguard certainly won't be put out of business when a better index-building methodology is established. He can expect, however, to watch as some new ETF provider becomes the Vanguard of tomorrow.

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