Fundamental indexing, or “smart beta” is an investing buzz word you might have heard before. It’s an investment strategy similar to index investing, and was introduced about ten years ago. Since then the strategy has grown to become rather popular.
Generally, when it comes to new and popular investment strategies I run for the hills. I learned early on that “this time it’s different” are incredibly dangerous words in the investing sphere.
But even though fundamental indexing is a newer strategy, I believe it merits an allocation in a well diversified portfolio. This post will explain what fundamental indexing is and why I think you should consider using it.
Before diving into fundamental indexing, let’s take a look at where traditional indexing came from.
Back in the early 1900s there wasn’t much of a market for stocks. If you wanted to invest in stocks you had to buy physical certificates from someone who had them on hand. In the big metropolitan areas like New York there were plenty of people wheeling and dealing these certificates (this is how the New York Stock Exchange started). But even if you could piece together a decent selection, building a well diversified portfolio was overly difficult.
Then in the late 1920s, the first mutual funds appeared. Established by Massachusetts Investors’ Trust, investors could buy shares of a diversified investment fund managed by a professional for the first time.
The mutual fund market expanded through the 50s and 60s, and by 1970 there were nearly 250 open ended mutual funds available to investors. These 250 funds were a far easier way for most people to invest, and billions poured into them from around the globe.
They weren’t without their shortcomings though. The trouble with mutual funds was that investors were forced to put blind faith into an investment manager’s stock picking ability. The mutual fund manager may be skilled, or they may not. And since very few investors could have a face to face or phone conversation with a mutual fund manager, many were not completely sold on the idea.
Enter Index Investing
Then in 1971 Wells Fargo Bank started the first index fund. It was a novel idea. Rather than trust a stranger to manage your money, you could invest in an index fund that simply replicated a given universe of securities. S&P 500 index funds simply bought all 500 stocks in the S&P 500. All the research & analysis a mutual fund manager would undergo to pick superior securities was stripped from the equation. And since investors didn’t need to pay a mutual fund manager’s salary, index funds were far less expensive.
This was the very idea that John Bogle used to build Vanguard into a massive investment company. He believed that investors are far better off investing in an index than they are purchasing actively managed mutual funds that attempt to outperform an index.
Bogle also believed that active investment managers were unable to pick outperforming securities (and avoid underperforming securities) on a consistent basis. Those who did were simply lucky.
The Active vs. Indexing Debate
The debate between which strategy is superior is fierce, and will probably rage on for eternity. Proponents of active management contend that in the long term, skillful mutual fund managers are still able to outperform index investing. This might be because they are particularly adept at analyzing securities or the market, or because they have some other type of advantage.
Like Bogle, those arguing in favor of indexing claim that managers who outperform an index do so only by luck, and there is no mutual fund manager alive who can consistently outperform their benchmark index. Therefore it makes no sense to incur the additional cost of active management.
Over the last decade or so, the evidence has pointed toward indexing. Fewer and fewer mutual funds are outperforming their benchmarks. And along with more low cost investing options, billions of dollars have flown out of actively managed and into index funds in each of the last 10 years.