Fundamentally based indexes

Fundamental weighting (also called “fundamental indexing”) is the practice of weighting stocks in an index by a fundamental factor (e.g. sales, book value, dividends) or composite of fundamental factors. This stands in direct contrast to capitalization-weighting. Fundamental weighting was pioneered by Research Affiliates, which first circulated research on fundamental indexing in mid-2004.

Rationale of Fundamental Weighting Versus Other Methods of Index Weighting

The traditional method of capitalization-weighting indices systematically overweights overvalued stocks and underweights undervalued stocks, assuming any price inefficiency. Since investors cannot observe the true fair value of a company, they cannot remove inefficiency altogether but can remove the systematic inefficiency that is inherent in capitalization-weighted indices. Equal-weighting is one method to remove this systematic inefficiency but suffers from high turnover, high volatility, and the requirement to invest potentially large sums in illiquid stocks.

Fundamental weighting avoids the pitfalls of equal weighting while still removing the systematic inefficiency of capitalization weighting. It weights industries by fundamental factors (also called “Main Street” factors ) such as sales, book value, dividends, earnings, or employees. If a stock’s price gets either too high or too low relative to its fair value, fundamental weighting will not reflect this bias. This prevents fundamentally weighted indices from participating in bubbles and crashes and thus reduces its volatility while delivering a higher return.

Empirical Evidence

Assuming the assumptions of the CAPM model do not hold, then the capitalization-weighted market portfolio is not efficient. Assuming any pricing inefficiency, even in the case of random noise, capitalization-weighting is sub-optimal and the degree of sub-performance is proportional to the degree of random noise.

Indices weighted by any of several fundamental factors including sales, cash flow, book value, or dividends in U.S. markets outperformed the Standard & Poor’s 500 by approximately 2% with volatility similar to the S&P 500. Thus, fundamentally weighted indices also had a higher Sharpe Ratio than capitalization-weighted indices. In non-U.S. markets, fundamentally weighted indices outperformed capitalization weighted indices by approximately 2.5% with slightly less volatility and outperformed in all 23 MSCI EAFE countries.

Criticisms and Responses

Since the first research was disseminated, fundamentally weighted indices have been criticized by proponents of capitalization weighting including John Bogle, Burton Malkiel, and Gus Sauter. Responses have come primarily from the publications of one of the founders of fundamental indexing, Robert Arnott.

Fundamentally weighted indices are really being actively managed. By avoiding capitalization weighting, they are making bets that certain stocks will outperform the market.

• Response: Although not necessarily generalizable, referring to his own company’s fundamental indices, Robert Arnott said, “Our fundamental index is formulaic, transparent, and is objectively and rigorously constructed.... The [free float capitalization weighted] S&P 500 is not objective. It is not formulaic. It is not transparent. And it is not replicable.”

Fundamentally weighted indices are exposed to the Fama French risk factors—that is they are value-biased and small cap-biased. These factors have historically led to outperformance. The current returns of fundamentally weighted indices are exaggerated because of the recent strong performance of value stocks.

• Response: It is true that the Fama French factors explain much of the returns of fundamentally weighted indices as they do for most passive portfolios. If they did not, it would demonstrate a flaw in the Fama French model. After controlling for Fama French risk factors, fundamental indices exhibit a small positive alpha—-albeit a statistically insignificant one—-as compared to other value-biased indexes that exhibit negative alpha like the S&P 500 Equal Weight or the Russell 1000 Value.

Fundamentally weighted indices have higher turnover and therefore higher costs than capitalization weighted indices.

• Response: Fundamentally weighted indices do have a higher turnover than capitalization weighted indices. However, the turnover is so low that its costs do not substantially affect returns. For example, the U.S. Fundamental Index 1000’s turnover ranges between 10 and 12 percent per annum versus 6% for an annually re-balanced capitalization-weighted index of the largest 1000 stocks. Furthermore, fundamentally weighted indices experience most of their turnover in large, liquid stocks while capitalization-weighted indices experience most of their turnover in small, illiquid stocks.

Fundamentally weighted indices have higher expense ratios than capitalization weighted ones. For example, the PowerShares fundamentally weighted ETFs have an expense ratio of 0.6% while the Pimco Fundamental IndexPLUS TR Fund charges 1.14% in annual expenses. In comparison, the Vanguard 500 Index Fund charges 0.18% per annum.

• Response: Fundamentally weighted ETFs do have higher expense ratios than capitalization-weighted ones but the 2 to 2.5% of additional returns per annum far outweigh the additional expenses incurred.

The 2 to 2.5% of additional returns that come from fundamental indexing are back-tested, and fundamental index funds have not been around long enough to draw any conclusions. We cannot know how the strategy will perform in the future.

• Response: The strategy has only been recently implemented, but the back-tested results come from multiple countries and over multiple time periods.