The historical evidence to support fundamentally weighted index-
ation is impressive. From 1964 through 2005, the compound annual re-
turn on a dividend-weighted index based on virtually all U.S. stocks was
11.88 percent per year, 123 basis points above a like capitalization-
weighted portfolio based on the same stocks while the volatility and
beta of the dividend-weighted portfolio was less than the capitalization-
weighted portfolio. This return outperformance with lower volatility
was reported across size sectors and internationally. Specifically, from
1996 through 2005, a dividend-weighted MSCI EAFE Index outper-
formed an EAFE Index by nearly 5^1 ⁄ 2 percentage points per year.^28
The long-term outperformance of fundamentally weighted indexes
principally relies on their emphasis of value-based strategies. Stocks with
higher-than-average dividend yields or lower-than-average P-E ratios
receive higher weights in fundamentally weighted indexes than capi-
talization-weighted indexes. But fundamentally weighted indexes are
better diversified than portfolios of only value stocks, and historically
they have had better risk-returns trade-offs. In any case, fundamen-
tally weighted indexes have very attractive characteristics that chal-
lenge the supremacy of capitalization-weighted indexes for long-term
investors.CONCLUSION
The past performance of actively managed equity funds is not encour-
aging. The fees that most funds charge do not provide investors with su-
perior returns and can be a significant drag on wealth accumulation.
Furthermore, a good money manager is extremely difficult to identify,
for luck plays some role in all successful investment outcomes.
When costs are taken into account, most actively managed funds
significantly lag the benchmark indexes. Index funds, be they capitaliza-
tion weighted or fundamentally weighted, are an extremely attractive
way to accumulate stocks for long-term investors.
But the past success of these capitalization-weighted indexes does
not mean that they will always remain the best choice for investors. The
enormous popularity of index funds, particularly those tied to the S&P
500 Index, cause prices of newly named stocks in the index to jump in
price, a phenomenon that will likely reduce future returns.
The development of fundamentally indexed portfolios may offer an
answer to some of the deficiencies of capitalization-weighted indexes.CHAPTER 20 Fund Performance, Indexing, and Beating the Market 357
(^28) More data can be found on the Web site at http://www.wisdomtree.com.