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Getting Index Weighting Straight

The debate over cap-weighted vs. fundamental indexing is a waste of time. Here's why.

The argument over cap-weighted indexing vs. fundamental indexing rages on. And with the plethora of ETFs available employing either one, the debate appears to be an important one. However, most articles seem to add very little new information, leaving the central question yet to be addressed: Should you care?

Over the weekend,

an article in

The New York Times

ably demonstrated what I'm talking about.

Indexing pioneer Jack Bogle is always quoted as saying something very negative, Jeremy Siegel and Robert Arnott are always quoted as saying something positive, but, of course, all three have some vested interest in their respective arguments. Bogle might be defending his legacy, and Siegel and Arnott are involved with investment products that fundamentally weight stocks into various indices.

As a quick primer, Bogle believes that weighting indices by market cap is the only way to go; other ideas tend to be faddish. Fundamental indexing constructs indices, and it weights the constituents using some sort of fundamental measure or blend of different fundamentals. Fundamental indexing is very new to the investing mainstream, whereas market-cap weighting is an old standby.

One luminary often quoted in these debates with seemingly no vested interest might be Burton Malkiel. He sides with Bogle, believing that cap weighting is the better way to go.

We can solve this issue right here, right now, for those of you who manage your own portfolio.

Are you ready?

It does not matter.

Cap weighting will be better sometimes, fundamental weighting will be better other times. There is no reason you, managing your own portfolio, even need to care which one is better. You can leave solving the world's indexing problems to other people.

Choosing a Path

The way a lot of articles debate the issue, you might think you need to choose one path and stick with it. I am a believer in fundamental indexing and have incorporated it into client accounts with the

WisdomTree International Energy Fund


. It is just one holding, and it has a small weight.

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Any of the various fundamentally weighted sector funds, from WisdomTree or PowerShares, could be the best way to capture certain sectors. By the same token, any of the cap-weighted sector funds, from iShares to the SPDRs, could also be the best to use, for some sectors.

Some investors construct portfolios just with cap size and/or growth and value. There is no reason that a fundamentally weighted fund like the

WisdomTree MidCap Dividend Index Fund

(DON) - Get WisdomTree U.S. MidCap Dividend Fund Report

couldn't be the best choice for mid-cap value. And couldn't a market-cap-weighted fund like

iShares S&P 600 Small-Cap Growth Fund

(IJT) - Get iShares S&P Small-Cap 600 Growth ETF Report

be the best way to capture small-cap growth? And how about a supposed gimmick like

Claymore Ocean Tomo Patent


for large-cap growth?

It is a certainty that none of the ETF methodologies that exist now -- and we haven't even touched on equal-weighting -- could be the single best method for every part of the market and for all times.

Index investing, if you feel the need to even label it, though your really don't have to, is not a green light to shortcuts and complete indifference. You are the steward for your own money. You have a certain obligation to yourself unless you plan to delegate to someone else. With all due respect to Mr. Bogle, the idea that indexing can't evolve no matter what seems counterintuitive.

Nobody Asked 'What If ...'

The other thing that is never touched on in these articles is the consequences if fundamental indexing turns out not to work. Looking at the

PowerShares FTSE RAFI US 1000

(PRF) - Get Invesco FTSE RAFI US 1000 ETF Report

, the first fundamentally weighted index fund, its top 10 holdings have six names in common with the

S&P 500 SPDR

(SPY) - Get SPDR S&P 500 ETF Trust Report

. The four in PRF's top 10, but not in SPY's top 10, are

General Motors

(GM) - Get General Motors Company Report



(CVX) - Get Chevron Corporation Report



(JPM) - Get JP Morgan Chase & Co. Report



(T) - Get AT&T Inc. Report

, which are all elsewhere in SPY. PRF is really just a different mix of the same names.

The back test and one year of actual trading clearly favors PRF, but a failure of PRF in the future will simply mean a performance lag.

The realistic difference will be a fairly highly correlated return between the two, with each one taking turns at having better short-term returns. In the longer run, I tend to put faith in fundamental indexing, but it is too soon for either side to declare victory.

At the time of publication, Nusbaum had no positions in any stocks mentioned, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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to send him an email.