E a Detailed Analysis of the Arguments for and Against Fundamental (Smart-Beta) Indexing

Part A

Provide a detailed analysis of the arguments for and against fundamental (smart-beta) indexing.

Against:

1. Fundamentally based indexes tend to have high turn-over than capitalization weighted indexes. Investors need to constantly rebalance the fundamental indexes portfolio whereas market weighted indexing portfolio is rebalanced automatically. For example, if the stock price doubles, the capitalization also doubles. There is no need to rebalance the cap-weighted portfolio. However, fundamental index requires constantly rebalance to ensure the portfolio are formed based on fundamental measurements. Arnott, Hsu and Moore (2005) suggest that the rebalancing periods are too long, the difference between the required weights and actual portfolio weights becomes so large that some of the suspected negative attributes associated with cap weighting may be reintroduced.

2. Fundamental weighting is less tax efficient than capitalization weighting. Because when the portfolio is rebalanced, fund managers need to sell a certain amount of the stock to keep the weights in balanced level. In this way, capital gains are realized which subject to higher tax rate. The more frequent you managed the portfolio, the higher tax you will need to pay. Taxes are a crucially important financial consideration because the premature realization of capital gains will substantially reduce net returns (Bogle and Malkiel, 2006)

3. Fundamentally indexes have higher turnover and therefore leading to higher costs than capitalization weighted indexes. Bogle and Malkiel (2006) warn that management fees of fundamentally-weighted funds are "well above the typical index fund." In the real world, after deducting the transaction and management costs, investors will probably earn little from the portfolio.

4. Fundamental weighting indexing tends to give more weight to companies with smaller size and so-called value stocks. The reason why this kind of indexing can often outperform other...