Fundamental indexing has been one of the hottest investment ideas in the mutual fund world, touted as a "new paradigm" for passive investors, but these funds haven't rewritten history yet. In fact, early returns from one of the most prominent fundamental indexing shops, WisdomTree Investments Inc., are less than groundbreaking.
Conventional index funds aim to match market results, betting that, with the help of razor-thin costs, they will be able to beat most stock-picking mutual funds over time. The funds are tried-and-true investment vehicles, collecting hundreds of billions in assets.
But recently, a number of high-profile index-fund critics have surfaced, arguing that these funds are flawed because traditional indexes weight companies by their market capitalization, or the total value of their outstanding shares -- a factor that reflects a big dose of market sentiment -- rather than more "fundamental" criteria, such as earnings or dividends.
Debate flared last summer when Wharton School professor Jeremy Siegel published an op-ed in The Wall Street Journal, promising that index investing was on "the verge of a revolution" and comparing skeptics to those who refused to believe the sun is at the center of the universe.
Days later, WisdomTree, a New York start-up with ties to Siegel and prominent hedge fund manager Michael Steinhardt, launched a family of exchange-traded funds designed around indexes that weight companies based on dividends, a factor WisdomTree argues is a better indicator of a company's real value.
Since then, WisdomTree, which manages about $3.9 billion in ETF assets, has touted the success of its funds based on hypothetical back-tests, data that show how the funds might have performed against traditional indexes like the Standard & Poor's 500 and the Russell 3000, had their investing methodology been used in the past.
However, earlier this month, the original 20 WisdomTree ETFs celebrated their first birthday, giving investors an initial glimpse at how these funds actually performed.
While returns are at best preliminary -- ideally, investors should look at three to five years, or even longer, to make a sound judgment -- WisdomTree's basic domestic style funds lagged ETFs that track conventional indexes from these three competitors practically across the board. WisdomTree's international funds did better than its domestic funds, outperforming other popular ETFs in a number of categories, but even there, returns were mixed.
On the domestic front, results were substantially the same whether WisdomTree funds were compared to competitors' balanced funds, which include value and growth stocks, or to competitors' value-oriented funds, which focus on companies with attractive financial ratios. Critics of fundamental indexing frequently argue that fundamental ETFs closely resemble value funds.
WisdomTree's international funds were typically compared only to competitors' balanced funds because there are relatively few international value ETFs available to investors.
Siegel said the assertions he made in his article last June are "still generally true" and, he believes, will be borne out in the long run. He attributes the WisdomTree funds' underperformance to a stock-market climate that has favored growth rather than value stocks and to WisdomTree funds' heavy investment in financial services companies, which have been hurt by problems in the mortgage industry.
"It's been a bull market over the past 12 months, and we've been hit by the subprime crisis," he says. "It has always been advertised as a multiyear, long-term strategy."
Of WisdomTree's original 20 funds, 12 have so far outperformed benchmarks the company assigned to them, said WisdomTree president Bruce Lavine.
Other WisdomTree funds that performed well relative to their benchmarks, such as the International SmallCap Dividend fund (DLS), which returned 43.81%, occupy thinly served market niches.
Still, some international WisdomTree funds, such as those aimed at Europe and Japan, failed to outperform rival offerings, and the company fared less well at home, where competition is more intense.
Ian Salisbury is a Dow Jones Newswires columnist.