Fundamentally based indexes

Fundamentally based indexes are indices in which stocks are weighted by a fundamental factor (e.g. sales, book value, dividends) or composite of fundamental factors. This stands in direct contrast to capitalization weighted indices. Fundamentally based indexes were pioneered by Research Affiliates, which first circulated research on the methodology in mid-2004.

Rationale of Weighting by Fundamentals 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.Hsu, Jason. "Journal Of Investment Management", Vol. 4, No. 3, (2006), pp. 1–10] 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.cite web|url=http://www.pimco.com/LeftNav/Product+Focus/2005/Arnott+Fundamental+Indexing+Interview.htm
month=June | year=2005|title=Rob Arnott Discusses the Fundamental Approach to Stock Market Indexing with PIMCO]

Weighting by fundamental factors avoids the pitfalls of equal weighting while still removing the systematic inefficiency of capitalization weighting.cite web|url=http://www.rallc.com/pubs/pdf/fundamentalIndexation.pdf
year=2005|title=Arnott, Robert. Hsu, Jason. Moore, Phil. "Fundamental Indexation." "Financial Analyst Journal". Volume 61. Number 2.|format=PDF] It weights industries by fundamental factors (also called "Main Street" factors [cite web|url=http://www.dallasnews.com/sharedcontent/dws/bus/scottburns/columns/2004/stories/112804dnbusburns2.9a325232.html|date=November 29, 2004|title=Burns, Scott. "Weight watching for funds." "The Dallas Morning News"] ) 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, weighting by fundamentals will not reflect this bias. This prevents fundamentally based indices from participating in bubbles and crashes and thus reduces its volatility while delivering a higher return.cite web|url=http://news.morningstar.com/article/pfarticle.asp?keyword=indexfunds&pfsection=Index|date=December 12, 2006|title=Morris, Sonya. "What's the Right Way to Index?"]

Empirical Evidence

If the assumptions of the CAPM do not hold, then the capitalization-weighted market portfolio is not efficient. [cite web|url=http://rallc.com/pubs/pdf/marketEfficiency.pdf|title=Markowitz, Harry. "Market Efficiency: A Theoretical Distinction and So What?". Financial Analysts Journal, Vol. 61, No. 5, pp. 17-30, September/October 2005.|format=PDF] 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. [Arnott, Robert. Hsu, Jason. Journal Of Investment Management, Vol. 5, No. 1, (2007), pp. 1–11.] [Treynor, Jack L. 2005. “Why Fundamental Indexing Beats Cap-Weighted Portfolios.”]

Indices weighted by any of several fundamental factors including sales, cash flow, book value, or dividends in U.S. markets outperformed the S&P 500 by approximately 2% with volatility similar to the S&P 500. Thus, fundamentally based indices also had a higher Sharpe Ratio than capitalization-weighted indices. In non-U.S. markets, fundamentally based indices outperformed capitalization weighted indices by approximately 2.5% with slightly less volatility and outperformed in all 23 MSCI EAFE countries.http://www.rallc.com/strategies/fundamentalIndexation.php]

Criticisms and Responses

Since the first research was disseminated, fundamentally based indexes 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 fundamentally based indexes, Robert Arnott.

Fundamentally based indexes are really being actively managed. By avoiding capitalization weighting, they are making bets that certain stocks will outperform the market. [cite web|url=http://advisor.morningstar.com/articles/doc.asp?docId=4110|date=June 24, 2005|title=Fund Times: Gross, Sauter speak at Morningstar Conference] [Lauricella, Tom. Gullapalli, Diya. “Not All Index ETFs Are What They Seem to Be.” Wall Street Journal. July 21st, 2006.]
*Response: Although not necessarily generalizable, referring to his own company’s fundamentally based indexes, 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 based 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 based indices are exaggerated because of the recent strong performance of value stocks. [cite web|url=http://www.economist.com/finance/displaystory.cfm?story_id=E1_RQNGQSP|date=December 13, 2006|title=Buttonwood. "Weights and Measures." "The Economist"] [cite web|url=http://www.investors.com/breakingnews.asp?journalid=34617590&brk=1|date=February 13, 2006|title=Spence, John. "ETFs claiming superior stock selection draw fire." "Investsor's Business Daily"] [Bogle, John C. Malkiel, Burton G. “Turn on a Paradigm?” Wall Street Journal, Page A-14. June 27th, 2006.]
*Response: It is true that the Fama French factors explain much of the returns of fundamentally based indexes 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, fundamentally based indexes 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. [cite web|url=http://etf.seekingalpha.com/article/4506|date= December 1, 2005|title=Rob Arnott Discusses Fundamental Indexes]

Fundamentally based indices have higher turnover and therefore higher costs than capitalization weighted indices. [cite web|url=http://etf.seekingalpha.com/article/3212|date=September 23, 2005|title=Rob Arnott and Fundamental Indexes Revisited]
*Response: Fundamentally based 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 [cite web|url=http://money.cnn.com/magazines/fortune/fortune_archive/2006/10/30/8391712/index.htm|date=October 30, 2006|title=Hajim, Corey. "A better way to index?" "Fortune"] [Hsu, Jason C. Campollo, Carmen. “New Frontiers in Index Investing.” Journal of Indexes. January / February 2006.] versus 6% for an annually rebalanced capitalization-weighted index of the largest 1000 stocks. Furthermore, fundamentally based indexes experience most of their turnover in large, liquid stocks while capitalization-weighted indices experience most of their turnover in small, illiquid stocks. [Arnott, Robert D. West, John M. “Fundamental Indexes: Current and Future Applications.” Institutional Investor's fifth annual Exchange-Traded Funds review.]

Fundamentally based indices have higher expense ratios than capitalization weighted ones. For example, the [http://www.powershares.com Powershares] fundamentally based ETFs have an expense ratio of 0.6% while the PIMCO Fundamental IndexPLUS TR Fund charges 1.14% in annual expenses. [Clements, Jonathon. “Getting Going When Good Index Funds Go Bad - The Case for a `Fundamental' Strategy.” Wall Street Journal. September 21st, 2006.] In comparison, the Vanguard 500 Index Fund charges 0.18% per annum. [cite web|url=http://money.cnn.com/magazines/moneymag/moneymag_archive/2006/09/01/8384564/index.htm|date=September 1, 2006|title=Wang, Penelope. "The Unlikeliest Bubble." "Money".]
*Response: Fundamentally based 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. [cite web|url=http://www.smartmoney.com/etffocus/index.cfm?story=20060816|date=August 16, 2006|title=Carrel, Lawrence. "Index Wars" SmartMoney.com]

The 2 to 2.5% of additional returns that come from fundamentally based indexes are back-tested, and fundamentally based 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.

Notes

External links

* [http://rallc.com/strategies/fundamentalIndexation.php Research Affiliates Fundamental Indexation Strategy]