Morningstar Advisor - Winter 2008 - 56

Morningstar Conversation per year compounded. Now, if people buy into the Fundamental Index concept based on an expectation that they’re going to add 6%, they’re making a terrible mistake. We are operating with the tailwind of a market in which value is sharply outperforming. If you look over the course of a growth/value cycle—where growth outperforms and then value outperforms—first, cap weighting gets the tailwind from growth; then, Fundamental Index gets the tailwind from value. Net net, we find Fundamental Index adds 2% to 2.5% a year over spans of time in which growth and value have the same returns. So I think adding that kind of incremental return is a sensible expectation, but adding the 6% we’ve seen this decade, not plausible. KK: It’s reasonable to point out, however, that The whole notion of capitalization weighting [c]ould have been nothing but a quaint, academically interesting concept. Rob Arnott the expenses of some of the funds that the strategy’s available through are higher than those of a traditional index fund. Aren’t you giving up some of the advantage that you’re pointing to? RA: I think Jack Bogle and I are on the same side with the angels on that. That is to say, we’re both big fans of low expense ratios. Relative to active management, the expense ratios of the Fundamental Index products are drastically lower. KK: So you view your competition as active management in that sense, instead of traditional indexes? RA: Both. KK: Because the debate between traditional RA: (Laughter) Fundamental Index is inherently a value-tilted concept relative to the capweighted markets. Now, the reason for that is actually very simple. With cap weighting, you take companies that are at twice the market multiple and you give them double their economic weight. Companies at half the market multiple, you give them half their economic weight. So cap weighting has a growth tilt relative to the economy. Fundamental Index is utterly neutral relative to the economy and, therefore, will always have a value tilt relative to the cap-weighted market. KK: If I were to look at some of your indexes growth to paying modest premiums for growth; it has gone from enormous industry concentrations based on perceived future growth, based on the new paradigm story, to having modest concentrations by industry. KK: Considering that we’ve been in a unique environment for smaller-cap stocks and value-oriented strategies, would you say that some of the returns that you’ve seen in the past 10 years are not immediately repeatable and that maybe expected returns will be a little bit lower, even if they’re better than traditional S&P 500-type strategies? RA: To be sure, coming off what in retrospect was the biggest bubble in U.S. capital markets’ history, the value added that we can expect from Fundamental Index will be much less than we’ve seen this decade. I haven’t checked the numbers recently, but for this decade to date, I think the value added has averaged over 6% today versus what they would have looked like, say, seven years ago, what would be some of the key differences? RA: Very modest differences. The one that’s changed is cap weighting. Cap weighting has gone from paying monumental premiums for indexing and fundamental indexing has been portrayed as the old guard of indexing versus the new guard. RA: Right. But it’s also worth noting that the S&P 500 Index fund that Vanguard pioneered wasn’t priced at seven basis points back in the early days. In the early days of indexing, the pricing tended to be a quarter to half percent. 56 Morningstar Advisor Winter 2008

Morningstar Advisor - Winter 2008

Table of Contents for the Digital Edition of Morningstar Advisor - Winter 2008

Morningstar Advisor - Winter 2008
Contents
Letter from the Editor
Inbox
How Do You Use the Morningstar Style Box?
Real Estate Investing Goes Global
The Golden Touch
Investment Briefs
Learning to Fly with Equity Options
Another Block in Building a Portfolio
In a League of Their Own
Unlock the Box
Fashion Change
The View from the Investment Side
Unpredictable Style
Weighting the Fundamentals
Wire-to-Wire Consistency
The Secret's Out
Focus on Financials
Strongest Homebuilders Will Withstand the Wrecking Ball
Breaking Style Conventions
Playing It Safe with Financials
Back to Bond School
Mutual Fund Analyst Picks
Undervalued Stocks
Most Popular Variable Annuities
New at Morningstar
The Style Counsel
Morningstar Advisor - Winter 2008 - Intro
Morningstar Advisor - Winter 2008 - Morningstar Advisor - Winter 2008
Morningstar Advisor - Winter 2008 - Cover2
Morningstar Advisor - Winter 2008 - 1
Morningstar Advisor - Winter 2008 - 2
Morningstar Advisor - Winter 2008 - Contents
Morningstar Advisor - Winter 2008 - 4
Morningstar Advisor - Winter 2008 - 5
Morningstar Advisor - Winter 2008 - 6
Morningstar Advisor - Winter 2008 - Letter from the Editor
Morningstar Advisor - Winter 2008 - 8
Morningstar Advisor - Winter 2008 - Inbox
Morningstar Advisor - Winter 2008 - How Do You Use the Morningstar Style Box?
Morningstar Advisor - Winter 2008 - 11
Morningstar Advisor - Winter 2008 - Real Estate Investing Goes Global
Morningstar Advisor - Winter 2008 - 13
Morningstar Advisor - Winter 2008 - 14
Morningstar Advisor - Winter 2008 - The Golden Touch
Morningstar Advisor - Winter 2008 - 16
Morningstar Advisor - Winter 2008 - 17
Morningstar Advisor - Winter 2008 - Investment Briefs
Morningstar Advisor - Winter 2008 - 19
Morningstar Advisor - Winter 2008 - 20
Morningstar Advisor - Winter 2008 - 21
Morningstar Advisor - Winter 2008 - Learning to Fly with Equity Options
Morningstar Advisor - Winter 2008 - 23
Morningstar Advisor - Winter 2008 - 24
Morningstar Advisor - Winter 2008 - 25
Morningstar Advisor - Winter 2008 - Another Block in Building a Portfolio
Morningstar Advisor - Winter 2008 - 27
Morningstar Advisor - Winter 2008 - 28
Morningstar Advisor - Winter 2008 - 29
Morningstar Advisor - Winter 2008 - In a League of Their Own
Morningstar Advisor - Winter 2008 - 31
Morningstar Advisor - Winter 2008 - 32
Morningstar Advisor - Winter 2008 - 33
Morningstar Advisor - Winter 2008 - 34
Morningstar Advisor - Winter 2008 - 35
Morningstar Advisor - Winter 2008 - Unlock the Box
Morningstar Advisor - Winter 2008 - 37
Morningstar Advisor - Winter 2008 - 38
Morningstar Advisor - Winter 2008 - 39
Morningstar Advisor - Winter 2008 - Fashion Change
Morningstar Advisor - Winter 2008 - 41
Morningstar Advisor - Winter 2008 - 42
Morningstar Advisor - Winter 2008 - 43
Morningstar Advisor - Winter 2008 - The View from the Investment Side
Morningstar Advisor - Winter 2008 - 45
Morningstar Advisor - Winter 2008 - 46
Morningstar Advisor - Winter 2008 - 47
Morningstar Advisor - Winter 2008 - 48
Morningstar Advisor - Winter 2008 - 49
Morningstar Advisor - Winter 2008 - 50
Morningstar Advisor - Winter 2008 - 51
Morningstar Advisor - Winter 2008 - Unpredictable Style
Morningstar Advisor - Winter 2008 - 53
Morningstar Advisor - Winter 2008 - Weighting the Fundamentals
Morningstar Advisor - Winter 2008 - 55
Morningstar Advisor - Winter 2008 - 56
Morningstar Advisor - Winter 2008 - 57
Morningstar Advisor - Winter 2008 - 58
Morningstar Advisor - Winter 2008 - 59
Morningstar Advisor - Winter 2008 - 60
Morningstar Advisor - Winter 2008 - 61
Morningstar Advisor - Winter 2008 - Wire-to-Wire Consistency
Morningstar Advisor - Winter 2008 - 63
Morningstar Advisor - Winter 2008 - 64
Morningstar Advisor - Winter 2008 - 65
Morningstar Advisor - Winter 2008 - The Secret's Out
Morningstar Advisor - Winter 2008 - 67
Morningstar Advisor - Winter 2008 - 68
Morningstar Advisor - Winter 2008 - 69
Morningstar Advisor - Winter 2008 - Focus on Financials
Morningstar Advisor - Winter 2008 - 71
Morningstar Advisor - Winter 2008 - 72
Morningstar Advisor - Winter 2008 - 73
Morningstar Advisor - Winter 2008 - Strongest Homebuilders Will Withstand the Wrecking Ball
Morningstar Advisor - Winter 2008 - 75
Morningstar Advisor - Winter 2008 - Breaking Style Conventions
Morningstar Advisor - Winter 2008 - 77
Morningstar Advisor - Winter 2008 - Playing It Safe with Financials
Morningstar Advisor - Winter 2008 - 79
Morningstar Advisor - Winter 2008 - 80
Morningstar Advisor - Winter 2008 - Back to Bond School
Morningstar Advisor - Winter 2008 - 82
Morningstar Advisor - Winter 2008 - Mutual Fund Analyst Picks
Morningstar Advisor - Winter 2008 - 84
Morningstar Advisor - Winter 2008 - 85
Morningstar Advisor - Winter 2008 - 86
Morningstar Advisor - Winter 2008 - 87
Morningstar Advisor - Winter 2008 - Undervalued Stocks
Morningstar Advisor - Winter 2008 - 89
Morningstar Advisor - Winter 2008 - 90
Morningstar Advisor - Winter 2008 - 91
Morningstar Advisor - Winter 2008 - Most Popular Variable Annuities
Morningstar Advisor - Winter 2008 - 93
Morningstar Advisor - Winter 2008 - New at Morningstar
Morningstar Advisor - Winter 2008 - 95
Morningstar Advisor - Winter 2008 - The Style Counsel
Morningstar Advisor - Winter 2008 - Cover3
Morningstar Advisor - Winter 2008 - Cover4
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