Fundamental investing fees will drop, predicts FTSE

Despite consistently outperforming the S&P/TSX 500, fundamental indexing still has its critics. One common complaint is that products connected to fundamental indexing have high fees. But according to Jerry Moskowitz, president of FTSE Americas, it’s only a matter of time until the price for investors is right.

“I think higher fees will be a challenge down the line and they’ll end up getting lower,” Moskowitz said before hosting a speech on fundamental indexing for Toronto’s financial community. He cites a recently launched American mutual fund that’s based on fundamental indexing, which has lower fees than many American ETFs. “It’s for competitive reasons,” he said.

Since November 2005, when FTSE launched their first set of fundamental indices, MERs have typically been higher on related ETFs and mutual funds, compared to market-cap-based products. The logic, said Moskowitz, is that fundamental indexes have been outperforming the market-cap method by about 200 basis points, so charging higher fees won’t really affect the investors bottom line. “Hopefully it’s an offset and you get higher return, so it doesn’t matter,” he said. “I think that’s a reasonable response for now.”

Moskowitz appears to be right — investors are buying into these ETFs and mutual funds despite higher fees. Globally, there are about $5 billion in assets invested in fundamental index products. In Canada, Claymore investments, which launched a fundamental ETF in February 2006, has $100 million in assets, despite charging a 65 bps fee.

Fundamental index’s allure is that it weights companies by accounting data, sales, book-equity value and dividends, as opposed to market capitalization. Proponents of the new type of indexing say it gives a fairer representation of the markets.

Jason Hsu, a principal director at Research Affiliates, the company that created fundamental indexing, cites the Nortel fiasco as a prime reason to avoid market-cap indexing. Essentially when companies grow, investors are forced to buy more of that organization and sell whatever has dropped in value. Nortel, for instance, accounted for 16% of the S&P/TSX 500 in 1999 and its demise forced the index down significantly. “It seems counterintuitive,” said Hsu about the way market-cap indices work. “It’s the opposite of buy low and sell high.”

Of course, when a bubble does occur that’s when fundamental investing doesn’t work as well as its counterpart. “In the tech boom this thing trailed by quite a bit because the market took off,” said Moskowitz. “But when the bubble broke the fundamental approach was outperforming by 400 to 500. So it caught up within 12 months because it didn’t go down anywhere near the market-cap.”

Since fundamental indexing is so new, Moskowitz’s numbers are from back data, and that’s drawn some criticism from fundamental opponents. “You want real data, that’s the best,” he said. “We verified all the back-testing and we were able to see that the numbers looked accurate to us. But like anything else, let’s see the real numbers.”

Despite having less than two years of actual data, Moskowitz said the numbers are “tracking exactly what the back-testing predicted, by being up between 200 and 220 bps on an annualized basis.”

On a global scale, Research Affiliates looked at data from December 1987 to June 2005 and found that all 23 countries that they back-tested all beat their respective cap-weighted benchmarks. In Canada the Research Affiliates Fundamental index returned 10.19% compared to the S&P/TSX 500’s return of 6.29%.

FTSE has a long way to go before people embrace fundamental indexing. Moskowitz said there’s still a lot of misconceptions about these indices, from the high fees, to people thinking this is active investing (“To us it’s a pretty passive approach,” he noted), to others calling it repackaged value investing.

But even when people do get excited about fundamental indexes, Moskowitz said this type of investing should really just compliment market-cap indexes, not replace them. “We’re not suggesting you drop all your investments in other indexes,” he said. “Good finance is diversified. (Though) we think this is a better investing vehicle.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com