One Answer to the Index Fund: Build a Better Index

PAUL A. SAMUELSON made a startling and significant case for index funds in 1974. In a deliberately provocative essay, Mr. Samuelson, who had already won the Nobel in economic science and written the most influential economics textbook in history, said most professional investment managers should “drop dead.”

At the very least, he said, they should “go out of business.”

When fees were included, nearly all stock and bond pickers could not reliably beat the overall market, he said, and the world would be better off if they just stopped trying. “Take up plumbing,” he advised. “Teach Greek,” or, maybe, work for a corporation â€" one that produced something useful. And he issued a challenge: Someone should set up a low-cost portfolio that tracks the Standard & Poor’s 500-stock index, allowing investors to match the returns of the overall stock market.

The essay did not win him many friends on Wall Street. But it struck a sympathetic chord in John C. Bogle, then in the early stages of founding Vanguard. “I took up the challenge,” he said in an interview last month.

On Aug. 31, 1976, with little fanfare, Mr. Bogle started the world’s first index mutual fund. Derided as “Bogle’s Folly,” the fund mirrored the performance of the S.& P. 500 â€" ensuring that, fees aside, investors would not do much worse than the index. They would not do better than the index, either. Merely matching the market â€" being “average” â€" seemed un-American to many mutual fund managers at the time. Yet the new index fund survived a rocky start and has become the immensely popular Vanguard 500 Index fund.

Today, while thousands of stock pickers and individual bond buyers still proudly ply their trades, index funds have swept the world. Including exchange-traded funds â€" nearly all of which are a form of index fund â€" more than $3 trillion in assets are now invested in index funds, according to the Investment Company Institute, the industry’s trade group. The question now is not whether low-cost, diversified, broad-market index funds have any value, it is how much they can be improved.

Mr. Bogle and current executives at Vanguard say the funds have gotten better through techniques that make them hew more closely to their underlying indexes and through economies of scale that enable them to cut costs.

Beyond that, Mr. Bogle said, innovation should not go. “People say they want to build a better mousetrap,” Mr. Bogle said. “Forgive me if I doubt it.”

But several companies say they already have created a better mousetrap â€" broad index funds that can beat the overall market, rather than merely matching it, even including fees.

“We don’t think you need to settle for average returns,” said Chris Brightman, the head of investment management for Research Affiliates, which says it has constructed so-called fundamental indexes that will deliver superior returns.

IN terms of performance, the verdict is not yet in. The performance of the newer indexes â€" and of the funds based on them â€" is close to that of the older ones. Sometimes the newer funds are better, sometimes they are worse. It may take decades to come up with a statistically valid test that will show whether tweaked index funds can regularly outperform the overall market â€" to say nothing of doing it consistently after the cost of the effort has been factored in.

Because the newer indexes are not tracking the overall stock or bond markets â€" and because they often have higher fees than the funds of Vanguard and some other traditional indexers â€" Alex Bryan, a Morningstar analyst, said, “I tend to think most people will be better off with very low-cost diversified funds of the kind sold by Vanguard.”

Still, funds based on indexes from two companies â€" Research Affiliates, based in Newport Beach, Calif., and WisdomTree, based in New York â€" have operated for more than five years, with generally good track records. These firms use criteria like dividend yield and corporate profit to create indexes â€" and index funds based on them â€" that are in some ways filtered versions of the broad indexes.

What is the argument for the new approaches? Jeremy J. Siegel, a professor of finance at the Wharton School of the University of Pennsylvania, and the author of “Stocks for the Long Run,” is senior investment strategy adviser at WisdomTree. He said that his research, and that of many other economists, showed that value stocks â€" those priced cheaply compared with the overall market â€" tended to outperform so-called growth stocks over long periods.

“Fundamental indexing captures this value effect very effectively,” he said.

Stocks with a smaller market capitalization have also tended to outperform larger-capitalization stocks, he said, pointing to research by Eugene F. Fama, the University of Chicago economist who is one of this year’s Nobel laureates.

Similarly, Research Affiliates uses several factors â€" including sales, cash flow, dividends and book value â€" to create fundamental indexes that are the basis of E.T.F.’s sold by PowerShares and Charles Schwab, Mr. Brightman said.

Traditional market indexes like those used at Vanguard are “definitely valid benchmarks for performance, but they have a basic drawback,” he said. Because these indexes are constructed on the basis of market capitalization â€" that is, a company like Apple with a huge market cap will have a much larger weight in the index than a company with a smaller market cap like AutoZone â€" an investor will inevitably end up holding a large dollop of companies whose share prices have already risen in value. “Buying low and selling high is the way to make money,” he said. But the rebalancing effect of market-cap-weighted indexes is to buy high and sell low.

“Fundamental indexes do the reverse,” Mr. Brightman said, “and that will produce better returns.”

In response, Fran Kinniry, a principal of Vanguard’s investment strategy group, said that Mr. Brightman and those who practice similar strategies were not really indexers at all. They are active managers â€" similar to stock pickers or strategists who try to time moves in the markets by altering their asset allocation.

“I don’t mean to be too cynical about this, but by every single definition an index is meant to measure the risk and returns of a particular asset class and it has to be market cap-weighted because that’s what the market is,” he said. “That’s our biggest concern. We’re not against actively managed funds at Vanguard. We’ve got many excellent funds that do that. But they’re not index funds.”

A third company, Dimensional Fund Advisors, based in Austin, Tex., takes a different approach. It does not operate index funds, in part, because “Vanguard already does that so well,” said David G. Booth, its chairman. Instead, he said in an interview, his firm uses research by Professor Fama, Kenneth R. French of Dartmouth and Robert C. Merton of M.I.T. to construct funds that are close cousins of index funds, but are intended to outperform them.

“We don’t try to outguess the market,” he said. “But we don’t try to get zero tracking error, either,” meaning that he is not troubled if D.F.A. funds veer from the day-to-day performance of the overall market. Instead, he said, his firm’s funds try to beat traditional indexes “by trading less than the index funds, or by trading at better times.” In addition, he said, the funds often have a greater small-cap value weighting than index funds.

“We’re not setting ourselves up as alternatives to index funds,” he added. “There’s nothing wrong with basic index funds.”

Many companies are trying other approaches aimed at using quantitative measures to beat the market.

For his part, Mr. Bogle said Dimensional Fund Advisors and the fundamental index managers all practiced a form of “active management.”

“Over the long run, I doubt very much that they can really beat the market,” he said, especially if their costs are higher than Vanguard’s, as they generally are.

“The problem is that you don’t know what will perform well in the future,” he said. And he pointed out that small-cap value stocks tended to be more volatile than the overall market, so investors were taking on more risk.

Professor Samuelson never ruled out the possibility that some active managers had enough “flair” to beat the market consistently. He just could not find this particular “subset” of people.

“What is interesting is the empirical fact that it is virtually impossible for academic researchers with access to the published records to identify any member of the subset with flair,” he wrote. “This fact, though not an inevitable law, is a brute fact.”