Morningstar Advisor - Spring 2008 - (Page 24) Gray Matters Index Types: A Matter of Great Weight Scheme Market Cap Methodology Weight of each stock is proportional to its market capitalization, usually adjusted for cross holdings and closely held shares. Example S&P 500 Pros r Represents the actual market. r Can be used as sole scheme for entire equity portfolio of all investors. r Fully scalable. r Very low turnover. Places the most weight on the stocks that provide the most income. Cons Becomes concentrated during extreme market run-ups. Total Dividend Weight of each stock is proportional to the total amount of dividends paid out to shareholders. Uses fundamental variables such as total revenues and book value to measure size instead of market capitalization. Morningstar Dividend Leaders r Not fully scalable. r Higher turnover than market-cap scheme. r Includes all stocks, but does not represent the actual market. r Cannot be used as sole scheme for entire equity portfolio of all investors. r Not fully scalable. r Higher turnover than market-cap scheme. r Small-company stocks highly overrepresented. r Very limited scalability. r High turnover. Fundamental Research Affiliates Fundamental Index r Provides a value tilt without excluding any stocks. r Maintains diversification during extreme market run-ups. Equal Weighting Assigns all stocks the same weight. S&P 500 Equally Weighted r Simple. r Provides a small-cap tilt without excluding any stocks. Collared Stocks with market-cap weights that are within bands around fundamental weights are held at market-cap weights, while stocks with marketcap weights outside bands are held at the bands. r Most of the portfolio is at market cap weights most of the time. r Maintains diversification during extreme market run-ups. r Less risk than either market-cap or fundamental schemes. r More scalable than fundamental scheme. r Moderate turnover. with the bath water by spurning market-value information, thereby completely ignoring risk and expected growth. The superior weighting scheme should be the one that makes the less egregious type of error. It stands to reason then that fundamental indexing is not the inevitably superior choice based on a revolutionary new theory. Instead, as critics point out, fundamental indexing is nothing more than value investing in a different guise. If a fundamentally weighted portfolio is to outperform a market-cap-weighted portfolio of the same stocks, the fundamental variables used to construct the weights must contain more information about the fair values of the stocks than the market values of the stocks contain. For example, if earnings are chosen as the fundamental weighting metric, then earnings must be a better indicator of a company’s true worth than the market price of its stock. In an article that I recently published in the Financial Analysts Journal (January/February 2008), I used a mathematical concept known as a boundary condition to help frame the question. Even though it cannot provide the ultimate answer, deriving this boundary condition can help us to better see the nature of the question and what conditions would have to be met for one method to be demonstrably better than the other. 24 Morningstar Advisor Spring 2008
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