Classic and Enhanced Index Funds Performance and Issues
EDWARD TOWER, Ph.D. Professor of Economics, Duke University Visiting Professor, Chulalongkorn University
This chapter discusses the construction of classic index funds and compares this approach with two applications of enhanced indexing. Fundamental indexation weights stocks in a portfolio by something other than market capitalization, such as dividends or earnings. Vanguard’s index funds generally use classic indexing, which weights equity shares in a portfolio according to market capitalization. Dimensional Fund Advisors (DFA) uses a combination of classic and fundamental indexation, and WisdomTree (WT) uses fundamental indexation. Following the discussion, the chapter compares the performance of equity portfolios from the three companies, using a modified system of style analysis developed by Sharpe (1992).
With classic capitalization-weighted indexing, fluctuations in stock prices do not require the index fund to buy or sell stocks. This reduces transaction costs. But transaction costs are incurred as a stock migrates between styles indexed by different funds. For example, a stock may grow from mid cap to large cap. As its price falls or its fundamentals improve, it may migrate from growth to value. However, Vanguard manages index funds that colonize different styles, so as a stock migrates between styles, Vanguard ought to be able to move it between its index funds at low cost. The transaction costs should ...