Posted August 25, 2012 by Joshua M Brown

The first popular fundamentally-weighted index products that I can remember were mutual funds from Rydex that took mainstream indexes and re-worked them so that they were weighted based on attributes other than simply market cap.  And then ETFs came along and latched on to this idea as soon as it became apparent that merely recreating a traditional cap-weighted index product would never be a high margin business especially so long as vanguard was in the game.

And so we got dividend-weighted ETFs and earnings growth-weighted ETFs and equal-weighted ETFs and on and on.

They were passively managed index products but at their core, they were active in the minds of the Old Jedis so long as they were doing anything other than owning the plain ol index on a cap-weighted basis.  Vanguards Jack Bogle still holds this view, but Rob Arnott (Research Affiliates, PIMCO) actually believes the opposite.

This is a fascinating give-and-take on the topic from an interview with Arnott at Index Universe:

Ludwig: When we talk about the pioneers of indexing, there are those who say that the baton must be passed at some point, and that perhaps you represent the next chapter. How do you respond to those views?

Arnott: Well, I have enormous respect for Jack. He is one of my heroes in this business. He is one of the pioneers. But as with so many pioneers, the ideas that spawned his and Vanguard’s meteoric success—that if you hold costs down, the customer gets more; and that since departures from the market are a zero-sum game, you should just hold the market—are very powerful ideas. But as with so many pioneers, he latches onto those ideas tenaciously and defends them fiercely. And so to him, Fundamental Indexing is active management in drag.

Ludwig: I was going to say you are in his cross hairs in some sense.

Arnott: He and I are friends. But this is one area of fierce disagreement. Another is ETFs.

Ludwig: Let’s start with the “active management in drag”—I love that formulation—then we’ll move on to ETFs.

Arnott: OK. Viewed from the perspective of classic cap-weighted indexation, Fundamental Indexing is active management. Any departure from cap weight is active management, viewed from that perspective. What a lot of people miss is that theres another perspective. Viewed from the vantage point of the macroeconomy, the cap-weighted market is making huge active bets. During the Internet boom, Cisco was 4 percent of the market, when it was 0.2 percent of the economy, and that’s a huge active bet. And so viewed from that perspective, Fundamental Indexing is studiously seeking to mirror the look and composition of the economy and using it as an anchor to contra-trade against the market’s constantly changing views, expectations, speculations, fads, bubbles and crashes.

That’s the elegance of Fundamental Indexing. Viewed from the vantage point of the macroeconomy, Fundamental Indexing does its best to be passive. And cap weight winds up loading up on growth companies, safe havens, weighting companies in proportion to their popularity.

Ludwig: So theres a whole lot of nuance here that we’re not getting from Jack Bogle? For example, I’m guessing you’ll concede the point that the line between active and passive management has blurred in the last two decades.

Arnott: It’s gotten blurrier and blurrier. And Fundamental Indexing has helped to make it even more blurry.

Ludwig: So you don’t dispute Bogle’s assertion that Fundamental Indexing is “active management in drag?”

Arnott: Actually, I don’t. I accept the notion that, from a cap-weight-centric world view, it is active management in drag. But I take it a step further, and I say: “That’s not the only world view.” From an economy-centric world view, Fundamental Indexing is passive and cap weight is active. It’s a little like looking at the world with one eye, or the other eye or with both.

Please take the time to read the full interview, Arnott is one of my must-reads and I try to see him speak whenever hes in New York.  This is a great window into his thoughts about allocation and investing.

Arnott: Emerging Markets Still Look Good (Index Universe)

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