In our previous post on the importance of seeking out smaller, entrepreneurial money managers was too long as it was we noted the fact that most ETF providers are controlled by public companies.

One of the points we made was that given the fact that most ETF providers are public companies they may be tempted to bring to market funds that stray from the original intent of the indexing movement. Don Phillips of Morningstar (MORN)* in the Journal of Indexes thinks that ever more narrow indexes are not not necessarily serving the best interest of investors. For instance we were irked that some would claim “asset class status” for IPOs on the launch of a new IPO-focused ETF.

The new wave of index funds are characterized by higher expenses, higher turnover, a narrower focus and more volatile. To Phillips these results are inimical to the original thesis behind indexed investing. In addition these funds are in all likelihood not well deployed by the mass of investors. The question is whether the ETF providers have a responsibility to the end users.

Continuing Bogle’s metaphor, some ETF providers may choose to take the stance that they are merely weapons manufacturers who bear little or no responsibility for how investors actually use their products. That’s essentially the stance taken by many mutual fund firms that launched Internet funds in the late 1990s; they were simply meeting market demand. Sadly, the celebration surrounding the rapid asset growth of several ETFs launched recently seems eerily similar to the euphoria around fast-selling Internet funds in the 1990s. The real success measure of any investment, however, is not how quickly it raises assets, but how much money it makes for investors over time.

Phillips believes there are some steps the ETF industry can take to help offset the potential harm these funds can do in the wrong hands. This includes increased educational efforts and the use of alternative weighting schemes, like fundamental indexes, that can reduce volatility. However worthwhile these steps might be we are skeptical that the ETF industry will slow this new fund arms race.

Fundamental indexes have received a great deal of attention, including this blog. One of our favorite financial writers William Bernstein at Efficient Frontier (via examines the claims of the fundamental indexing crowd. Bernstein looks at the factor loadings of the new fundamental index in search of some alpha. Instead of alpha, Bernstein finds that roughly two thirds of the claimed outperformance of the RAFI index is due to factor loadings and one third can reasonably be claimed to be due to “technique.”

Bernstein has two conclusions which are in synch with Don Phillips earlier comments.

1. Fundamental indexing is a promising technique, but its advantage over more conventional cap-weighted value-oriented schemes, to the extent that it exists at all, is relatively small. Attempts should be made to confirm this work within a multifactor framework both abroad and with pre-Compustat U.S. data.

2. Even assuming that fundamental indexation produces returns in excess of its factor exposure, caution should be used in the practical application of this methodology. Differences in the expenses, fees, and transactional costs incurred in the design and execution of real-world portfolios can easily overwhelm the relatively small marginal benefits of any one value-oriented approach. The prospective shareholder needs to consider not only the selection paradigm used, but just who is executing it.

Phillips and Bernstein would probably agree on this point. Just because you can build and launch an ETF, doesn’t mean you should. As Bernstein writes the real-world costs can quickly overwhelm even a well-designed process. We would add that fundamental indexing is one of the better ones proposed. The hurdle for a fund launch, in a sense, should be higher than the cost of the paperwork at the SEC.

*We should note that Morningstar is not exactly a disinterested party in this discussion. Morningstar has licensed indices to iShares for use in ETFs.

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