Fundamental Indexes: Investing More Intelligently
Is There An Alternative To Market-Cap Weighting?
Having established that market-cap weighting can lead to over- and undervaluation problems, causing return drag, the question is how to go about breaking this link. In 2002, Robert Arnott and his eam at Research Affiliates came up with the idea of creating an index that measures profits rather than market-capitalization, taking stock price out of the equation. A very simple idea, the concept is to measure company weight within an index by Main Street’s standards of size rather than Wall Street’s. In other words, company size and performance are determined by four fundamental factors – sales, cash flows, book values, and dividends. These four factors were selected based on their differences. What one factor did not account for, another would, thereby mitigating the vulnerability of any given factor. The result is a fundamental index, an index showing more stability in stock weighting and less volatility overall, which in more than 60 years of back-testing outperforms capweighted models.
Bringing An Alternative To Market
In mid-2005, the first fundamental indexes came to market. The first fundamental index series went live in November of 2005, beginning with 24 indexes covering global markets.
Thus far, these indexes have outperformed their market-cap counterparts in various economic and market conditions including bull and bear markets, rising and falling interest rates, economic expansions and contractions. In bear markets, fundamental indexes provided a five per cent value add and almost four per cent in recessions. In bull markets, they tend to perform as well, if not better than capweighted indexes. Tests of fundamental index concepts using market data go back as far as 1962, before which point there is not enough market information to support this type of research. These show an annualized return of 12.5 per cent, compared with 10.4 per cent for the S&P 500. (Chart 1)
Performance data also demonstrates that in the Canadian market, these indexes have historically outperformed the S&P/TSX 60. For example, a $10,000 investment in 1999 would have grown to $25,726 by year’s end, 2006. Conversely, the same $10,000 investment tracking the S&P/TSX 60 would have only been worth about $17,011 at that time. (Chart 2)
Early adopters of this approach included plan sponsors and financial services providers who recognized that this was an important advance in equity management and that the idea would likely attract substantial assets. Among these plan sponsors were the California Public Employee Retirement System (CalPERS) and the South Dakota Investment Council who began using fundamental indexes to compliment their traditional passive investments.
It is no secret that fundamental indexes are a new and controversial concept. Academics and financial industry heavyweights alike have claimed that fundamental indexes are based on backward-looking data, while others say that they are simply value indexes that favor small cap and value stocks, which historically tend to have better performance than large cap and growth stocks. Some critics even say that fundamental indexes are not indexes at all, but rather an active strategy.
Despite skepticism, with assets under management now exceeding $12 billon, the concept is rapidly gaining in popularity. Proponents argue they eliminate the return drag inherent in cap-weighted indexes and, furthermore, outperform cap-weighted indexes equivalents by two per cent per annum in the United States and 3.5 per cent globally.
Given the performance data, it makes for a very strong alternative and compliment to any portfolio.
Jerry Moskowitz is president of FTSE Americas.
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