Fundamentally Weighted Index Investing
Index investing is the staple for many investors. They select a fund that matches a well-known index, and then sit back to watch their investments grow with the market. Now investors have a growing variety of indexes to choose from.
In the past, there were the capitalization-weighted indexes, which include the S&P 500 and the Russell 2000. The DJIA is a price-weighted index. Based on the efficient market theory (EMT), these indexes have been the basis for many investment vehicles for investors including mutual funds and exchange traded funds (ETFs).
The new choices in index investing involve fundamentally weighted indexes, which are based on one or more factors such as book value, cash flow, revenue, sales or dividends. These indexes are offering investors new options to invest their hard-earned capital. Here we look at the benefits and risks of using fundamentally weighted indexes as an investment vehicle.
Capitalization-Weighted Indexes
Let's start with the basis for capitalization-weighted indexes to establish some background for the discussion. The capital asset pricing model (CAPM) is the foundation for a number of index models, especially the capitalization-weighted indexes such as the S&P 500. Basically, CAPM assumes that cash flows can be determined into the future on every investment. This helps identify the true value of each security. Because the market is efficient, it will properly match the price of the asset to its CAPM-determined value. Efficient market theory states that a stock's price reflects the market's best estimates of the firm's underlying true value at any given time. (To continue reading about the CAPM, seeThe Capital Asset Pricing Model: An Overview, Catch On To The CCAPM and Financial Concepts.)
When True Value Isn't True
But what if the price ends up above or below the "true value"? Does this mean the true value is wrong? Not necessarily, although it does mean that each security is going to trade above or below its ultimate true value. If every security is trading above or below its true value, then capitalization-weighted indexes are going to be overexposed to every security trading above their true fair values and underexposed to assets trading below their true fair values.
If investors put more of their money in securities that are above fair value and less money in securities that are below fair value, they will get a lower return. It also means that the capitalization-weighted indexes generate returns that are below what is possible. In a capitalization-weighted index, every stock that is overvalued is overweighted, while those that are undervalued are underweighted.
Breaking Down Value
Here's an example to help explain the performance of a capitalization-weighted index compared to, say, an equal-weight index. In an equal-weight index, it is even odds as to whether the overvalued stock will be over- or under-bought. Equal weighting under-weights every stock that's large, regardless of whether it's expensive, and overweights each stock that's small, regardless of whether it's expensive.
Suppose there are only two stocks in the market and, according to CAPM, each has a true value of $1,000. One stock is estimated by the market to be worth $500, while for the other the market places a value of $1,500. The capitalization-weighted index would place 75% of the total portfolio in the overvalued stock and 25% of the total portfolio in the undervalued stock. The equal-weighted index requires that an investor place the same amount in each stock in his or her portfolio. In other words, each stock would comprise 50% of the portfolio regardless of whether it is over- or undervalued.
Five years later, the valuation errors are corrected and both stocks come to be valued at $1,000. In this case, if you had based your portfolio on a capitalization-weighted index, your return would be zero. On the other hand, an investor who placed her money in the equal-weighted index would experience a return of 33.5%. The lower priced stock would earn $1,000 for the portfolio, while the higher priced stock would lose $330 for the portfolio. The table below presents this example.
This is where fundamentally-weighted indexes offer an alternative. "Fundamental Indexation," a study released in 2005 by Rob Arnott, Jason Hsu and Phillip Moore argued that fundamentally index portfolios outperformed the S&P 500, a traditional capitalization-weighted index, by approximately 2% per year for the 43 years of the study. The fundamental factors used in the study were book value, cash flow, revenue, sales, dividends and employment.
While 2% might seem small, when compounded, it doubles the size of an investor's portfolio in 35 years. Clearly, this represents a better return compared to the traditional capitalized-weighted returns. Keep in mind that studies show that many mutual funds underperform the overall market. Therefore, where investors place their long-term investments makes a real difference over the years, although this backtesting did not include the impact of fees and taxes. (To see more on compounding, see Understanding The Time Value Of Money.)
The Positive Side
The argument for fundamentally-weighted indexes is that the price of a stock is not always the best estimate of the true underlying value of the company. Prices can be influenced by speculators, momentum traders, hedge funds and institutions that buy and sell stocks for reasons that may not be related to the underlying fundamentals, such as for tax purposes. These influences can impact the price of a stock for days or for years, making it difficult to create an investing strategy that can consistently produce superior returns. (For more information see What Are Fundamentals?)
The theory is that if the price of a stock falls for reasons not related to its fundamentals, then it is likely, although not certain, that overweighting this stock will generate higher-than-average returns. Similarly, stocks with prices that rise more than their fundamentals would indicate become overpriced stocks and are likely to underperform the market.
Like capitalization-weighted indexes, fundamental indexes do not require that an investor analyze the underlying securities. However, they must be rebalanced periodically by purchasing more shares of firms with prices that have gone down more than a fundamental metric, such as dividends paid, and selling shares in firms with prices that have risen more than the fundamental metric. (To read more about this subject, see A Guide To Portfolio Construction, Asset Allocation Strategies and Rebalance Your Portfolio To Stay On Track.)
As more indexes are created, investors will have new investment alternatives to match to their investing needs and personal styles. Income investors might want to consider dividend-based indexes, while growth investors might favor sectors that they believe will grow faster than the overall market.
The Argument Against
So what are the downsides to fundamentally-weighted index investments? First, the cost to own funds based on fundamentally-weighted indexes can be higher than the capitalized-weighted indexes. Because fundamentally-weighted indexes are still young, there isn't sufficient history to assess whether this increased expense will persist. Proponents of fundamentally-weighted indexes claim that they will experience higher turnover than capitalization-weighted indexes due to the necessity to adjust the portfolio to match the fundamental factors. However, they have not yet achieved the cost efficiency of the large index funds. As a result, their expenses may be higher as a result of their smaller size. They must be rebalanced periodically by buying and selling shares to bring the fund into compliance with the index, and they will incur trading expenses similar to capitalized-weighted indexes. Therefore, it is possible that the cost of fundamentally-weighted index investments will fall as they achieve the size of capitalization-weighted indexes.
The other criticism of fundamental indexing is that this new approach may not pass the test of time, as the market has a strong tendency to revert to the mean. It is interesting to note that since 1937, value and growth funds have performed very similarly, experiencing 10.62% and 10.59% growth in value. This implies that no matter which approach an investor chooses, over time, they may produce similar results.
The believers in fundamental indexes point out that repeated research by Kenneth French from Dartmouth's Tuck School and the University of Chicago's Eugene Fama, have shown that small cap and value stocks have outperformed other securities over most significant historical periods, and haven't yet displayed a reversion to the mean. This doesn't mean it won't happen, it just means that there are opportunities to beat the market with fundamentally-weighted indexes, if investors understand the risks. It seems that Benjamin Graham and his disciple, Warren Buffett understood this concept year ago. Graham is quoted as saying, "In the short run, the market is a voting machine, but in the long run, it is a weighing machine."
As fundamentally-weighted indexes become more popular, there is a growing number of ways to invest through mutual funds and ETFs. Investors interested in funds that are based on fundamentally-weighted indexes should treat these investment opportunities just like any other investment. They should perform the necessary analysis before committing their capital. Depending on one's personal situation, this includes understanding the performance of the global and regional economies, finding sectors that offer the best opportunity and assessing fundamentals that offer the best potential returns.
Aiming to Outperform
Finally, in order for fundamentally-weighted funds to outperform the S&P 500, a common benchmark, investors have to believe in two assumptions:
In the past, there were the capitalization-weighted indexes, which include the S&P 500 and the Russell 2000. The DJIA is a price-weighted index. Based on the efficient market theory (EMT), these indexes have been the basis for many investment vehicles for investors including mutual funds and exchange traded funds (ETFs).
The new choices in index investing involve fundamentally weighted indexes, which are based on one or more factors such as book value, cash flow, revenue, sales or dividends. These indexes are offering investors new options to invest their hard-earned capital. Here we look at the benefits and risks of using fundamentally weighted indexes as an investment vehicle.
Capitalization-Weighted Indexes
Let's start with the basis for capitalization-weighted indexes to establish some background for the discussion. The capital asset pricing model (CAPM) is the foundation for a number of index models, especially the capitalization-weighted indexes such as the S&P 500. Basically, CAPM assumes that cash flows can be determined into the future on every investment. This helps identify the true value of each security. Because the market is efficient, it will properly match the price of the asset to its CAPM-determined value. Efficient market theory states that a stock's price reflects the market's best estimates of the firm's underlying true value at any given time. (To continue reading about the CAPM, seeThe Capital Asset Pricing Model: An Overview, Catch On To The CCAPM and Financial Concepts.)
When True Value Isn't True
But what if the price ends up above or below the "true value"? Does this mean the true value is wrong? Not necessarily, although it does mean that each security is going to trade above or below its ultimate true value. If every security is trading above or below its true value, then capitalization-weighted indexes are going to be overexposed to every security trading above their true fair values and underexposed to assets trading below their true fair values.
If investors put more of their money in securities that are above fair value and less money in securities that are below fair value, they will get a lower return. It also means that the capitalization-weighted indexes generate returns that are below what is possible. In a capitalization-weighted index, every stock that is overvalued is overweighted, while those that are undervalued are underweighted.
Breaking Down Value
Here's an example to help explain the performance of a capitalization-weighted index compared to, say, an equal-weight index. In an equal-weight index, it is even odds as to whether the overvalued stock will be over- or under-bought. Equal weighting under-weights every stock that's large, regardless of whether it's expensive, and overweights each stock that's small, regardless of whether it's expensive.
Suppose there are only two stocks in the market and, according to CAPM, each has a true value of $1,000. One stock is estimated by the market to be worth $500, while for the other the market places a value of $1,500. The capitalization-weighted index would place 75% of the total portfolio in the overvalued stock and 25% of the total portfolio in the undervalued stock. The equal-weighted index requires that an investor place the same amount in each stock in his or her portfolio. In other words, each stock would comprise 50% of the portfolio regardless of whether it is over- or undervalued.
Five years later, the valuation errors are corrected and both stocks come to be valued at $1,000. In this case, if you had based your portfolio on a capitalization-weighted index, your return would be zero. On the other hand, an investor who placed her money in the equal-weighted index would experience a return of 33.5%. The lower priced stock would earn $1,000 for the portfolio, while the higher priced stock would lose $330 for the portfolio. The table below presents this example.
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This is where fundamentally-weighted indexes offer an alternative. "Fundamental Indexation," a study released in 2005 by Rob Arnott, Jason Hsu and Phillip Moore argued that fundamentally index portfolios outperformed the S&P 500, a traditional capitalization-weighted index, by approximately 2% per year for the 43 years of the study. The fundamental factors used in the study were book value, cash flow, revenue, sales, dividends and employment.
While 2% might seem small, when compounded, it doubles the size of an investor's portfolio in 35 years. Clearly, this represents a better return compared to the traditional capitalized-weighted returns. Keep in mind that studies show that many mutual funds underperform the overall market. Therefore, where investors place their long-term investments makes a real difference over the years, although this backtesting did not include the impact of fees and taxes. (To see more on compounding, see Understanding The Time Value Of Money.)
The Positive Side
The argument for fundamentally-weighted indexes is that the price of a stock is not always the best estimate of the true underlying value of the company. Prices can be influenced by speculators, momentum traders, hedge funds and institutions that buy and sell stocks for reasons that may not be related to the underlying fundamentals, such as for tax purposes. These influences can impact the price of a stock for days or for years, making it difficult to create an investing strategy that can consistently produce superior returns. (For more information see What Are Fundamentals?)
The theory is that if the price of a stock falls for reasons not related to its fundamentals, then it is likely, although not certain, that overweighting this stock will generate higher-than-average returns. Similarly, stocks with prices that rise more than their fundamentals would indicate become overpriced stocks and are likely to underperform the market.
Like capitalization-weighted indexes, fundamental indexes do not require that an investor analyze the underlying securities. However, they must be rebalanced periodically by purchasing more shares of firms with prices that have gone down more than a fundamental metric, such as dividends paid, and selling shares in firms with prices that have risen more than the fundamental metric. (To read more about this subject, see A Guide To Portfolio Construction, Asset Allocation Strategies and Rebalance Your Portfolio To Stay On Track.)
As more indexes are created, investors will have new investment alternatives to match to their investing needs and personal styles. Income investors might want to consider dividend-based indexes, while growth investors might favor sectors that they believe will grow faster than the overall market.
The Argument Against
So what are the downsides to fundamentally-weighted index investments? First, the cost to own funds based on fundamentally-weighted indexes can be higher than the capitalized-weighted indexes. Because fundamentally-weighted indexes are still young, there isn't sufficient history to assess whether this increased expense will persist. Proponents of fundamentally-weighted indexes claim that they will experience higher turnover than capitalization-weighted indexes due to the necessity to adjust the portfolio to match the fundamental factors. However, they have not yet achieved the cost efficiency of the large index funds. As a result, their expenses may be higher as a result of their smaller size. They must be rebalanced periodically by buying and selling shares to bring the fund into compliance with the index, and they will incur trading expenses similar to capitalized-weighted indexes. Therefore, it is possible that the cost of fundamentally-weighted index investments will fall as they achieve the size of capitalization-weighted indexes.
The other criticism of fundamental indexing is that this new approach may not pass the test of time, as the market has a strong tendency to revert to the mean. It is interesting to note that since 1937, value and growth funds have performed very similarly, experiencing 10.62% and 10.59% growth in value. This implies that no matter which approach an investor chooses, over time, they may produce similar results.
The believers in fundamental indexes point out that repeated research by Kenneth French from Dartmouth's Tuck School and the University of Chicago's Eugene Fama, have shown that small cap and value stocks have outperformed other securities over most significant historical periods, and haven't yet displayed a reversion to the mean. This doesn't mean it won't happen, it just means that there are opportunities to beat the market with fundamentally-weighted indexes, if investors understand the risks. It seems that Benjamin Graham and his disciple, Warren Buffett understood this concept year ago. Graham is quoted as saying, "In the short run, the market is a voting machine, but in the long run, it is a weighing machine."
As fundamentally-weighted indexes become more popular, there is a growing number of ways to invest through mutual funds and ETFs. Investors interested in funds that are based on fundamentally-weighted indexes should treat these investment opportunities just like any other investment. They should perform the necessary analysis before committing their capital. Depending on one's personal situation, this includes understanding the performance of the global and regional economies, finding sectors that offer the best opportunity and assessing fundamentals that offer the best potential returns.
Aiming to Outperform
Finally, in order for fundamentally-weighted funds to outperform the S&P 500, a common benchmark, investors have to believe in two assumptions:
- Whatever causes valuation errors, which gave rise to the superior historical returns of fundamentally-weighted indexes, will continue into the future (value investing will not revert to the mean); and
- The market will recognize that overvalued stocks will eventually revert to the mean, rather than remain overvalued.
by
Hans Wagner
As a long time investor, Hans Wagner was able to retire at 55 by following a disciplined process using sound investment principles. After his children and their friends graduated from college, Hans began helping them to invest in the stock market. Soon, friends and acquaintances also began to seek advice, so Hans created a website, Trading Online Markets, which provides information on investing topics, along with sample portfolios.
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