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Publication: Investor's Notebook
THE LOOMING BATTLE

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        Investor's Insight - November 14, 2006           
          "A Digest of Investment Opinion From the 
             World's Leading Financial Advisers"

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THE LOOMING BATTLE: FUNDAMENTAL VS. TRADITIONAL INDEXING
by Scott Burns

Ideas have consequences.

If the idea works, those who bet on it make money. If it 
doesn't work, they lose money.

Today, the biggest idea battle in investments is between 
"fundamental indexing" and "market-capitalization indexing."

In traditional market-capitalization indexing you repli-
cate an existing market exactly as it exists. Then you 
trust that you'll earn the return of that asset class, 
less tiny fees. 

The best-known example of this is the Vanguard 500 index 
fund. The object of mockery when it was launched in 1976, 
it has done better than 70 percent of its managed large-
cap blend competitors over the last 10- and 15-year per-
iods. Along the way it has accumulated nearly $70 billion 
in assets. It thrived while multitudes of managed compet-
itors were quietly buried.

The first recent challenge to traditional indexing came 
from Robert Arnott and his firm, Research Affiliates. 
Launched last December, the Powershares RAFI 1000 index 
(ticker: PRF) returned 14.65 percent for the first 10 
months of this year, while the Vanguard 500 index return-
ed "only" 11.90 percent.

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During the summer, Wisdom Tree began a full-scale assault 
on market-capitalization indexing. It launched an arsenal 
of 20 "fundamental index" exchange-traded funds that cover 
the major markets of the entire world. "In contrast to cap-
weighted indexing, fundamentally weighted indexes anchor 
the initial weights of individual stocks to some metric 
of fundamental value," the Wisdom Tree Web site says.

While the RAFI 1000 index is based on a basket of fun-
damental measures, the Wisdom Tree funds are keyed to 
a single fundamental -- dividends. They do this because 
"cash dividends provide an objective measure of a com-
pany's value and profitability -- one that cannot be 
manipulated by accounting schemes."

Basically, the indexes give us the hope of being paid more 
now while we hope to be paid still more in capital gains 
later. Back-testing them from 1980 through 2005 showed 
that the idea appears to work. Wisdom Tree Dividend index 
returned 14.71 percent annually, while the Wilshire 5000 
index returned 12.87 percent. Similarly, the Wisdom Tree 
Small Cap Dividend index returned a whopping 17.15 per-
cent, while the Russell 2000 index returned 12.14 percent.

Over the 10 years ending March 31, 2006, Wisdom Tree's 
Pacific ex-Japan High-Yielding Equity index returned a 
stunning 16.66 percent, while the MSCI Pacific Rim ex-
Japan value index returned only 6.91 percent and the MSCI 
Pacific Rim ex-Japan index returned 5.65 percent.

Does this mean we should pile in?

I don't think so. When you index stocks with primary 
attention to dividends, you create a portfolio that is 
likely to be concentrated in a few industries. You also 
create a portfolio that is highly sensitive to interest
rates.

Purchase the Wisdom Tree Small Cap Dividend index ETF, 
for instance, and you'll be purchasing an index that is 
a whopping 60 percent financial stocks. That's almost 
three times the weighting of financial stocks in the
Russell 2000 index.

Purchase the Wisdom Tree Large Cap Dividend fund and 30 
percent of your money will be committed to financial 
stocks. (In contrast, only 22 percent of the Standard & 
Poor's 500 index or the Russell 1000 index is in finan-
cial stocks.)

Why should we worry about this?

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History. 

Electric utility stocks were the darlings of the early 
1960s. They were praised for their high yields and their 
healthy growth rates. Those who invested with enthusiasm 
suffered for nearly 20 years while interest rates rose 
and price-to-earnings multiples collapsed. 

The same fate may await a portfolio dominated by financial 
stocks.

Decades of research show that there are only two consis-
tent sources of higher returns in the stock market: small-
cap stocks and "value" stocks -- those with low 
price-to-book-value ratios. Those are the areas for fun-
damental indexing to pursue.

Skeptics should consider the track record of Dimensional 
Funds Advisors, the original fundamental indexer. Its 
Small Cap Value fund, a rules-based fundamental index, 
has returned 15.60 percent annually over the last 10 
years. That puts it at the top of the small-cap value 
fund heap. 

Similarly, its Large Cap Value fund has returned 12.08 
percent a year over the last 10 years, placing it in the 
top 4 percent of large-cap value funds.

Why haven't you heard of them?

Simple: The minimum investment in either fund is $2 
million, unless you work through a financial adviser.

You can discuss this issue or any other topic in the new 
Investor's Insight forum. Check it out here...

 
Investor's Insight Forum

(Investor's Insight reflects the opinions of experts. It does 
not recommend any specific investments, and no endorsement is 
implied or should be inferred. For more information, contact 
the individual firms cited).

COPYRIGHT 2006 UNIVERSAL PRESS SYNDICATE

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