Siegel vs Bogle on Index Funds

I am a fan of both Jeremy Siegel (Wharton economist and author of "Stocks for the Long Run") and John Bogle (Vanguard founder and index fund pioneer). I am therefore fascinated by the intellectual and financial battle between them. Here it is, as reported in today's New York Times:

According to Mr. Siegel, there is a “revolution” under way, a “new paradigm” in which the traditional indexes like the S.& P. 500 will make way for fundamental indexing, which constructs indexes based on measures like companies that pay dividends, rather than just a company’s size.

Perhaps not surprisingly, the company Mr. Siegel advises, WisdomTree, whose chairman is Michael H. Steinhardt, the legendary former hedge fund manager, has been active in developing these indexes and sponsoring exchange-traded funds based on them....

Mr. Siegel says the central problem with traditional index funds, which are weighted by market capitalization, is that they overweight overvalued stocks and underweight undervalued stocks. Historically, value stocks outperform growth stocks, so an index should be constructed to invest in the cheaper value stocks rather than the expensive growth stocks.

“We should be shifting to another paradigm to look at how markets work,” Mr. Siegel said in an interview. “I don’t think the price of a stock is always in line with fundamentals. I think there are a lot of factors, which helps to explain a lot of what we see in the capital markets.”

Mr. Bogle disagrees. “Beware when you hear about the new paradigm,” he said yesterday. “I think the claims they make are outrageous." He refers to some of the data provided to back up the premises of WisdomTree as “data mining.”

I am placing my bets with Bogle on this one. Bogle's position has the virtue of an economic theory to back it up: the efficient markets hypothesis. The hypothesis is probably not exactly true, but it may be true enough to make it sensible for typical investors to follow its prescriptions.

By contrast, Siegel thinks markets are inefficient. But if that is so, why not advocate active money management? The answer, presumably, is that active money management has historically not done as well as passive management. But that fact seems to undermine the basic premise of the funds that Siegel is promoting.

Siegel's position appears to be that active money managers aren't smart enough to beat the market but his mechanical rule is. I am skeptical. The hubris that makes active management often fail may also infect economists who make up mechanical rules.

Finally, tax efficiency is important in taxable investment accounts. It is hard to beat the market, but it is easier to beat the IRS by a combination of (1) focusing on capital gains over dividends and (2) deferring capital gains realization via reduced portfolio turnover. Tax efficiency argues in favor of the traditional index funds that Bogle recommends.