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. An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions. ...

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.^[1] 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.^[2] In finance, the efficient market hypothesis (EMH) asserts that financial markets are informationally efficient, or that prices on traded assets, e. ... Investment is a term with several closely related meanings in finance and economics. ... Definition Fair value, also called fair price, is a concept used in finance and economics. ... Look up company in Wiktionary, the free dictionary. ... Volatility most frequently refers to the standard deviation of the change in value of a financial instrument with a specific time horizon. ... Market liquidity is a business or economics term that refers to the ability to quickly buy or sell a particular item without causing a significant movement in the price. ...

Weighting by fundamental factors avoids the pitfalls of equal weighting while still removing the systematic inefficiency of capitalization weighting.^[3] It weights industries by fundamental factors (also called "Main Street" factors ^[4]) such as sales, book value, dividends, earnings, or employees.^[3] 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.^[5] Main Street in Los Altos, California. ... Sales, or the activity of selling, forms an integral part of commercial activity. ... The book value of an asset or group of assets is sometimes the price at which they were originally acquired (historic cost), in many cases equal to purchase price. ... A dividend is the distribution of profits to a companys shareholders. ... Income, generally defined, is the money that is received as a result of the normal business activities of an individual or a business. ... Employment is a contract between two parties, one being the employer and the other being the employee. ... This article does not cite its references or sources. ... A stock market bubble is a type of economic bubble taking place in stock markets when price of stocks rise and become overvalued by any measure of stock valuation. ... Black Monday (1987) on the Dow Jones Industrial Average A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market. ...

Empirical Evidence

Assuming the assumptions of the CAPM do not hold, then the capitalization-weighted market portfolio is not efficient.^[6] 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.^[7][1][8] An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial Average over the last 3 years for monthly data. ... A market portfolio is a portfolio consisting of a weighted sum of every asset in the market, with weights in the proportions that they exist in the market (with the necessary assumption that these assets are infinitely divisible). ...

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 based indices also had a higher Sharpe Ratio than capitalization-weighted indices.^[3] 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.^[9] The S&P 500 is a list of 500 US corporations, ordered by market capitalization. ... The Sharpe ratio is a measure of risk-adjusted performance of an investment asset, or a trading strategy. ... The MSCI EAFE Index is an index of foreign stocks. ...

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. Research is a human activity based on intellectual investigation and aimed at discovering, interpreting, and revising human knowledge on different aspects of the world. ... John C. (Jack) Bogle (b. ... Burton Gordon Malkiel (born August 28, 1932) is an American economist and writer, most famous for his classic finance book A Random Walk Down Wall Street (now in its 8th edition, 2003). ...

Fundamentally based indexes are really being actively managed. By avoiding capitalization weighting, they are making bets that certain stocks will outperform the market.^[10][11] A comparison of three major stock indices: the NASDAQ Composite, Dow Jones Industrial Average, and S&P 500. ... Active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming a benchmark index. ...

• 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.”^[2]

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.^[12][13][14] Eugene F. Fama. ... Small-cap refers to stocks that have a small market capitalization. ...

• 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.^[15]

Fundamentally based indices have higher turnover and therefore higher costs than capitalization weighted indices.^[16] Passive management (also called passive investing) is a financial strategy in which a fund manager makes as few portfolio decisions as possible, in order to minimize transaction costs, including the incidence of capital gains tax. ... The alpha coefficient () is a parameter in the Capital Asset Pricing Model. ... In statistics, a result is significant if it is unlikely to have occurred by chance, given that a presumed null hypothesis is true. ... The S&P 500 is an index containing the stocks of 500 Large-Cap corporations, most of which are American. ... The Russell Indexes (note that Russell uses Indexes rather than Indices) are a set of stock indexes of listed US companies. ... Look up Turnover in Wiktionary, the free dictionary. ...

• 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^[17][18] 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.^[19]

Fundamentally based indices have higher expense ratios than capitalization weighted ones. For example, the Powershares fundamentally based ETFs have an expense ratio of 0.6% while the PIMCO Fundamental IndexPLUS TR Fund charges 1.14% in annual expenses.^[20] In comparison, the Vanguard 500 Index Fund charges 0.18% per annum.^[21] Market liquidity is a business or economics term that refers to the ability to quickly buy or sell a particular item without causing a significant movement in the price. ... The Pacific Investment Management Company, LLC manages $400 billion, mostly in bond funds. ... Vanguard is an American investment management company that offers mutual funds and other financial products and services to individual and institutional investors in the United States and abroad. ...

• 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.^[22]

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.^[5]

• Response: The strategy has only been recently implemented, but the back-tested results come from multiple countries and over multiple time periods.^[3][9]

Notes

1. ^ ^{a b} Hsu, Jason. Journal Of Investment Management, Vol. 4, No. 3, (2006), pp. 1–10
2. ^ ^{a b} Rob Arnott Discusses the Fundamental Approach to Stock Market Indexing with PIMCO (June 2005).
3. ^ ^{a b c d} Arnott, Robert. Hsu, Jason. Moore, Phil. "Fundamental Indexation." Financial Analyst Journal. Volume 61. Number 2. (2005).
4. ^ Burns, Scott. "Weight watching for funds." The Dallas Morning News (November 29, 2004).
5. ^ ^{a b} Morris, Sonya. "What's the Right Way to Index?" (December 12, 2006).
6. ^ Markowitz, Harry. "Market Efficiency: A Theoretical Distinction and So What?". Financial Analysts Journal, Vol. 61, No. 5, pp. 17-30, September/October 2005..
7. ^ Arnott, Robert. Hsu, Jason. Journal Of Investment Management, Vol. 5, No. 1, (2007), pp. 1–11.
8. ^ Treynor, Jack L. 2005. “Why Fundamental Indexing Beats Cap-Weighted Portfolios.”
9. ^ ^{a b} http://www.rallc.com/strategies/fundamentalIndexation.php
10. ^ Fund Times: Gross, Sauter speak at Morningstar Conference (June 24, 2005).
11. ^ Lauricella, Tom. Gullapalli, Diya. “Not All Index ETFs Are What They Seem to Be.” Wall Street Journal. July 21st, 2006.
12. ^ Buttonwood. "Weights and Measures." The Economist (December 13, 2006).
13. ^ Spence, John. "ETFs claiming superior stock selection draw fire." Investsor's Business Daily (February 13, 2006).
14. ^ Bogle, John C. Malkiel, Burton G. “Turn on a Paradigm?” Wall Street Journal, Page A-14. June 27th, 2006.
15. ^ Rob Arnott Discusses Fundamental Indexes (December 1st, 2005).
16. ^ Rob Arnott and Fundamental Indexes Revisited (September 23, 2005).
17. ^ Hajim, Corey. "A better way to index?" Fortune (October 30, 2006).
18. ^ Hsu, Jason C. Campollo, Carmen. “New Frontiers in Index Investing.” Journal of Indexes. January / Feburary 2006.
19. ^ Arnott, Robert D. West, John M. “Fundamental Indexes: Current and Future Applications.” Institutional Investor's fifth annual Exchange-Traded Funds review.
20. ^ Clements, Jonathon. “Getting Going When Good Index Funds Go Bad - The Case for a `Fundamental' Strategy.” Wall Street Journal. September 21st, 2006.
21. ^ Wang, Penelope. "The Unlikeliest Bubble." Money. (September 1, 2006).
22. ^ Carrel, Lawrence. "Index Wars" SmartMoney.com (August 16, 2006).

External links

• Research Affiliates Fundamental Indexation Strategy