What is Index Investing?
Index investing ("Indexing") is one of the fastest growing investment genres, utilized heavily by both professional and individual investors. The advantages of indexing include lower costs and reduced tracking error. Further, the expansion of index investing has encouraged new ideas and innovations, such as Fundamental Indexing (“Fundamental”).
Fundamental Versus Cap-Weighted
Fundamental initially generated attention by offering an alternative to the much more common Market Capitalization Indexing (“Cap-weighted”). Historically, individual securities within an index were determined simply by market capitalization — the composition of an index directly reflected the relative size of a company in the market as determined by multiplying price by shares outstanding (Price x Shares Outstanding = Market Capitalization). Fundamental changed the conversation, conversely using an index construction methodology based on factors such as revenue, debt-to-equity, the number of employees, and other balance sheet and income statement factors. A company no longer had to be weighted in relation to its market capitalization — a variation on indexing that Fundamental’s inventors and early adopters have claimed significantly improves performance.
Today, the performance debate continues regarding fundamental versus cap-weighted, with strong data supporting assertions from both sides. Yet, if index investors are looking to determine which methodology clearly performs better, they are searching in vain. Investors must begin to perceive the decision between Cap-weighted and Fundamental as a philosophical one. Indexing itself gave investors an important alternative to traditional stock picking and shined an even brighter light on the examination of active versus passive investment management. Now, Fundamental allows investors to have a broader discussion beyond the endless bickering about supposed outperformance. It is not just about performance, or at least it should not be. Which index methodology is better has a lot more to do with metaphysical deep-thinking than data. The decision whether to index using Fundamental or Cap-weighted rests on one question: Are you a mindful investor?
Determining Value Based on Intrinsic Factors
If you can comprehend what markets truly represent, you will recognize that markets are a microcosm of human behavior and prices are mostly driven by other people’s actions and emotions. When we view markets, we are not observing an efficient mechanism for assigning value, rather the emotions of billions of individuals compacted into the price of an asset. We do not like to acknowledge this, but our behavior as investors parallels our behavior as individuals, where we innately judge ourselves by what other people think rather than what we personally know. In our lives, sometimes we foolishly let family, friends and even strangers control our opinion of ourselves. And in our portfolios, Cap-weighted Indexing allows others to value our investments from the outside by affecting price and therefore index composition. Value, unfortunately, typically comes from the outside-in.
For a considerable time, indexing meant riding along with other investors as their emotions pushed prices up and down. We allowed others to impact the constituents of our indices and did so because of a familiarity with the same behavior in our everyday lives. However, mindfulness teaches us to stop focusing on other people’s behavior and look inside ourselves for value, and Fundamental is a new option that allows us to turn a similar new leaf in our portfolios. Mindfully, this relatively new way to index shuns outside price influence and prefers to value its components using intrinsic factors. And though it can be scary at first to adopt new habits, the practice of finding value from the inside is a fruitful one.
The Bottom Line
The popularity of indexing has spurred competition in the marketplace. And that competition has fostered many advancements including the innovation of Fundamental indices. Mindful investing, like mindful living, comes from the inside-out and is more objective — it creates opportunity while reducing risk. With the advent of Fundamental Indexing, mindful investors now have an investment vehicle that enables them to more effectively implement their smart, unemotional philosophy.