Fundamentally based indexes
Encyclopedia
Fundamentally based indexes are indices
in which stocks are weighted by one of many economic fundamental factors, especially accounting figures which are commonly used when performing corporate valuation, or by a composite of several fundamental factors. A potential benefit with composite fundamental indices is that they might average out specific sector biases which may be the case when only using one fundamental factor. A key belief behind the fundamental index methodology is that underlying corporate accounting/valuation figures are more accurate estimators of a company's intrinsic value, rather than the listed market value of the company, i.e. that one should buy and sell companies in line with their accounting figures rather than according to their current market prices. In this sense fundamental indexing is linked to so-called Fundamental Analysis
.
The fundamental factors commonly used by fundamental index managers are sales, earnings, book value, cash flow and dividends. Even the number of employees have been used in empirical studies on fundamental indexation. Fundamental indices are often contrasted to capitalization-weighted indices. Fundamentally based indices were arguably pioneered by Research Affiliates, which first circulated research on the methodology in mid-2004. However, the method is in practice very similar to the so-called Core Equity Strategy-method launched by Dimensional Fund Advisors
during the same year. They are similar since DFA weight by small caps and value stocks in a direct way whereas Research Affiliates weight by small caps and value stocks in a more indirect way. Furthermore, fundamental indexation is also seen by some people as merely a practical application and repackaging of the findings of one of the most famous journal articles in modern financial economics: "The Cross-Section of Expected Stock Returns" by Fama & French (1992). This is because the key characteristic of fundamental indices is that they have a combined relative small cap and value stock tilt vs. a capitalization-weighted index, which is for example explicitly shown in a Swedish context by Olof Andersson (2009) in his Thesis "Irrational Indexation". Fundamental indices ride on the small cap and the value stock premiums which have been present in international stock markets during the last 30–40 years so it is not strange that they might beat the market. Thus, a fundamental index does not actually buy companies in line with only their accounting figures, but rather companies with high accounting figures which at the same time exhibit low market values. A fundamental index is thus not really value indifferent indexing contrary to claims of its inventors. The current challenge of fundamental index managers is to conclusively prove that their index funds provide more value than merely riding on the small cap and the value stock premium, if possible, in order to legitimate the fees charged by these managers. There is some evidence, statistical significance, that fundamental indices create more value but there is yet any evidence known of economic significance.
. Since investors cannot observe the true fair value
of a company
, they cannot remove inefficiency altogether but can arguably remove the systematic inefficiency that is arguably inherent in capitalization-weighted indices. Equal-weighting
is one method to remove this claimed inefficiency but suffers from high turnover, high volatility
, and the requirement to invest potentially large sums in illiquid stocks
.
Weighting by fundamental factors avoids the pitfalls of equal weighting while still removing the claimed systematic inefficiency of capitalization weighting. It weights industries by fundamental factors (also called "Main Street
" factors ) 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 as far as there is not perfect correlation between stock prices and economic fundamentals. However, the correlation is quite close since the economic fundamentals used are commonly driving the value of a stock. If we assume no correlation in line with Robert Arnott, this arguably prevents fundamentally based indices from participating in bubbles
and crashes
and thus reduces its volatility while delivering a higher return. However, the dismal performance of fundamental indices in 2008 when companies such as banks with large fundamentals crashed has shown that it may not prevent it from participating in stock market crashes. When fundamentals change rapidly so may the stock price.
do not hold then there could be three states of the world in line with the so-called joint hypothesis problem explained by Campbell (1997):
If we assume that the capitalization-weighted market portfolio is not efficient, assuming a pricing inefficiency, capitalization-weighting might be sub-optimal and the degree of sub-performance might be proportional to the degree of random noise.
Forty years of back-tested Indices weighted by any of several fundamental factors including sales, ebit, earnings, cash flow, book value, or dividends in U.S. markets outperformed the S&P 500
by approximately 2% per annum 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.
Financial economists — Walkshäusl and Lobe — investigate the performance of global and 50 country-specific (28 developed and 22 emerging) fundamentally weighted indices compared to capitalization-weighted indices between 1982 to 2008. First, they establish that superior performance of domestic indices diminishes considerably when applying a bootstrap procedure for robust performance testing. Second, even after controlling for data snooping biases and the value premium, they find evidence that fundamental indexing produces economically and statistically significant positive alphas. This holds for global and country-specific versions which are heavily weighted in the world portfolio.
was disseminated, fundamentally based indices have been criticized by proponents of capitalization weighting including John Bogle
, Burton Malkiel
, and William Sharpe
. The opposing opinions rely heavily on opposing assumptions. Proponents claiming a new revolutionary paradigm in index fund investing such as for example Robert D. Arnott
, Jeremy Siegel
and Jack Treynor — all affiliated with fundamental index funds — assume somewhat irrational markets whereas the opponents mentioned — some affiliated with conventional index funds — assume more rational and efficient markets.
Basically, the claimed rationale behind fundamental indexation is argued to be fundamentally flawed by Perold (2007), Kaplan (2008), and Malkiel (2003)). Responses have come primarily from the publications of one of the founders of fundamentally based indices, Robert Arnott.
Index fund
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.-Tracking:Tracking can be achieved by trying to hold all of the...
in which stocks are weighted by one of many economic fundamental factors, especially accounting figures which are commonly used when performing corporate valuation, or by a composite of several fundamental factors. A potential benefit with composite fundamental indices is that they might average out specific sector biases which may be the case when only using one fundamental factor. A key belief behind the fundamental index methodology is that underlying corporate accounting/valuation figures are more accurate estimators of a company's intrinsic value, rather than the listed market value of the company, i.e. that one should buy and sell companies in line with their accounting figures rather than according to their current market prices. In this sense fundamental indexing is linked to so-called Fundamental Analysis
Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
.
The fundamental factors commonly used by fundamental index managers are sales, earnings, book value, cash flow and dividends. Even the number of employees have been used in empirical studies on fundamental indexation. Fundamental indices are often contrasted to capitalization-weighted indices. Fundamentally based indices were arguably pioneered by Research Affiliates, which first circulated research on the methodology in mid-2004. However, the method is in practice very similar to the so-called Core Equity Strategy-method launched by Dimensional Fund Advisors
Dimensional Fund Advisors
Dimensional Fund Advisors is an investment firm headquartered in Austin, Texas with regional offices in Amsterdam, Berlin, London, Santa Monica, Sydney, and Vancouver. The company was founded in 1981 by David G. Booth and Rex Sinquefield, both graduates of the University of Chicago Booth School of...
during the same year. They are similar since DFA weight by small caps and value stocks in a direct way whereas Research Affiliates weight by small caps and value stocks in a more indirect way. Furthermore, fundamental indexation is also seen by some people as merely a practical application and repackaging of the findings of one of the most famous journal articles in modern financial economics: "The Cross-Section of Expected Stock Returns" by Fama & French (1992). This is because the key characteristic of fundamental indices is that they have a combined relative small cap and value stock tilt vs. a capitalization-weighted index, which is for example explicitly shown in a Swedish context by Olof Andersson (2009) in his Thesis "Irrational Indexation". Fundamental indices ride on the small cap and the value stock premiums which have been present in international stock markets during the last 30–40 years so it is not strange that they might beat the market. Thus, a fundamental index does not actually buy companies in line with only their accounting figures, but rather companies with high accounting figures which at the same time exhibit low market values. A fundamental index is thus not really value indifferent indexing contrary to claims of its inventors. The current challenge of fundamental index managers is to conclusively prove that their index funds provide more value than merely riding on the small cap and the value stock premium, if possible, in order to legitimate the fees charged by these managers. There is some evidence, statistical significance, that fundamental indices create more value but there is yet any evidence known of economic significance.
Rationale of weighting by fundamentals versus other methods of index weighting
The traditional method of capitalization-weighting indices might by definition imply overweighting overvalued stocks and underweighting undervalued stocks, assuming a price inefficiencyEfficient market hypothesis
In finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.There are...
. Since investors cannot observe the true fair value
Fair value
Fair value, also called fair price , is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such objective factors as:* acquisition/production/distribution costs, replacement costs,...
of a company
Company
A company is a form of business organization. It is an association or collection of individual real persons and/or other companies, who each provide some form of capital. This group has a common purpose or focus and an aim of gaining profits. This collection, group or association of persons can be...
, they cannot remove inefficiency altogether but can arguably remove the systematic inefficiency that is arguably inherent in capitalization-weighted indices. Equal-weighting
Arithmetic mean
In mathematics and statistics, the arithmetic mean, often referred to as simply the mean or average when the context is clear, is a method to derive the central tendency of a sample space...
is one method to remove this claimed inefficiency but suffers from high turnover, high volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
, and the requirement to invest potentially large sums in illiquid stocks
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
.
Weighting by fundamental factors avoids the pitfalls of equal weighting while still removing the claimed systematic inefficiency of capitalization weighting. It weights industries by fundamental factors (also called "Main Street
Main Street
Main Street is the metonym for a generic street name of the primary retail street of a village, town, or small city in many parts of the world...
" factors ) such as sales
Sales
A sale is the act of selling a product or service in return for money or other compensation. It is an act of completion of a commercial activity....
, book value
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's book value...
, dividends, earnings
Earnings
Earnings are the net benefits of a Corporation's operation. Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are used as EBIT -- earnings before interest and taxes, EBITDA - earnings before...
, or employees. If a stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
’s price gets either too high or too low relative to its fair value, weighting by fundamentals will not reflect this bias as far as there is not perfect correlation between stock prices and economic fundamentals. However, the correlation is quite close since the economic fundamentals used are commonly driving the value of a stock. If we assume no correlation in line with Robert Arnott, this arguably prevents fundamentally based indices from participating in bubbles
Stock market bubble
A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation....
and crashes
Stock market crash
A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors...
and thus reduces its volatility while delivering a higher return. However, the dismal performance of fundamental indices in 2008 when companies such as banks with large fundamentals crashed has shown that it may not prevent it from participating in stock market crashes. When fundamentals change rapidly so may the stock price.
Empirical evidence
If the assumptions of the CAPMCapital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
do not hold then there could be three states of the world in line with the so-called joint hypothesis problem explained by Campbell (1997):
- The capitalization-weighted market portfolioMarket portfolioMarket 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....
is not efficient. - The CAPM model is not an efficient pricing model.
- Both the cap-weighted market portfolio and the CAPM model are inefficient.
If we assume that the capitalization-weighted market portfolio is not efficient, assuming a pricing inefficiency, capitalization-weighting might be sub-optimal and the degree of sub-performance might be proportional to the degree of random noise.
Forty years of back-tested Indices weighted by any of several fundamental factors including sales, ebit, earnings, cash flow, book value, or dividends in U.S. markets outperformed the S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
by approximately 2% per annum with volatility similar to the S&P 500. Thus, fundamentally based indices also had a higher Sharpe ratio
Sharpe ratio
The Sharpe ratio or Sharpe index or Sharpe measure or reward-to-variability ratio is a measure of the excess return per unit of deviation in an investment asset or a trading strategy, typically referred to as risk , named after William Forsyth Sharpe...
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
MSCI EAFE
The MSCI EAFE Index is a stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada...
countries.
Financial economists — Walkshäusl and Lobe — investigate the performance of global and 50 country-specific (28 developed and 22 emerging) fundamentally weighted indices compared to capitalization-weighted indices between 1982 to 2008. First, they establish that superior performance of domestic indices diminishes considerably when applying a bootstrap procedure for robust performance testing. Second, even after controlling for data snooping biases and the value premium, they find evidence that fundamental indexing produces economically and statistically significant positive alphas. This holds for global and country-specific versions which are heavily weighted in the world portfolio.
Criticisms and responses
Since the first researchResearch
Research can be defined as the scientific search for knowledge, or as any systematic investigation, to establish novel facts, solve new or existing problems, prove new ideas, or develop new theories, usually using a scientific method...
was disseminated, fundamentally based indices have been criticized by proponents of capitalization weighting including John Bogle
John Bogle
John Clifton "Jack" Bogle is the founder and retired CEO of The Vanguard Group. He is known for his 1999 book Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor, which became a bestseller and is considered a classic.-Early life and education:Bogle was born in in Verona, New...
, Burton Malkiel
Burton Malkiel
Burton Gordon Malkiel is an American economist and writer, most famous for his classic finance book A Random Walk Down Wall Street...
, and William Sharpe
William Sharpe
William Sharpe may refer to:*William Sharpe , delegate to the Continental Congress from North Carolina*William Forsyth Sharpe , Nobel Prize-winning economist*William Sharpe...
. The opposing opinions rely heavily on opposing assumptions. Proponents claiming a new revolutionary paradigm in index fund investing such as for example Robert D. Arnott
Robert D. Arnott
Robert D. Arnott is an American entrepreneur, investor, editor and writer who focuses on articles about quantitative investing. He is the father of Richard Wiles-Arnott, Sydney Arnott, and Robin Arnott. He edited the CFA Institute's Financial Analysts Journal from 2002–2006, and has edited three...
, Jeremy Siegel
Jeremy Siegel
Jeremy James Siegel is the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania in Philadelphia, Pennsylvania...
and Jack Treynor — all affiliated with fundamental index funds — assume somewhat irrational markets whereas the opponents mentioned — some affiliated with conventional index funds — assume more rational and efficient markets.
Basically, the claimed rationale behind fundamental indexation is argued to be fundamentally flawed by Perold (2007), Kaplan (2008), and Malkiel (2003)). Responses have come primarily from the publications of one of the founders of fundamentally based indices, Robert Arnott.
- Fundamentally based indexesStock market indexA stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....
are really being actively managedActive managementActive management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...
. By avoiding capitalization weighting, they are making bets that certain stocks will outperform the market.- Response: Although not necessarily generalizable, referring to his own company’s fundamentally based indices, Robert ArnottRobert D. ArnottRobert D. Arnott is an American entrepreneur, investor, editor and writer who focuses on articles about quantitative investing. He is the father of Richard Wiles-Arnott, Sydney Arnott, and Robin Arnott. He edited the CFA Institute's Financial Analysts Journal from 2002–2006, and has edited three...
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.”
- Response: Although not necessarily generalizable, referring to his own company’s fundamentally based indices, Robert Arnott
- 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 during the last 30 years and the outperformance of small cap stocks.
- Response: It is true that the Fama French factors explain much of the returns of fundamentally based indices as they do for most passive portfoliosPassive managementPassive management is a financial strategy in which an investor invests in accordance with a pre-determined strategy that doesn't entail any forecasting...
. If they did not, it would demonstrate a flaw in the Fama French model. After controlling for Fama French risk factors, fundamentally based indices exhibit a small positive alpha—-albeit a statistically insignificantStatistical significanceIn statistics, a result is called statistically significant if it is unlikely to have occurred by chance. The phrase test of significance was coined by Ronald Fisher....
one—-as compared to other value-biased indices that exhibit negative alpha like the S&P 500S&P 500The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
Equal Weight or the Russell 1000Russell 1000The Russell 1000 Index is a stock market index that represents the highest-ranking 1,000 stocks in the Russell 3000 Index, which represents about 90% of the total market capitalization of that index. The Russell 1000 Index has a weighted average market capitalization of $81 billion; the median...
Value.
- Response: It is true that the Fama French factors explain much of the returns of fundamentally based indices as they do for most passive portfolios
- Fundamentally based indices have higher turnover and therefore higher costs than capitalization weighted indices.
- 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 versus 6% for an annually rebalanced capitalization-weighted index of the largest 1000 stocks. Furthermore, fundamentally based indices experience most of their turnover in large, liquidMarket liquidityIn business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
stocks while capitalization-weighted indices experience most of their turnover in small, illiquid stocks.
- 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 versus 6% for an annually rebalanced capitalization-weighted index of the largest 1000 stocks. Furthermore, fundamentally based indices experience most of their turnover in large, liquid
- Fundamentally based index funds have higher expense ratios than the traditional capitalization weighted index funds. 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. In comparison, the VanguardThe Vanguard GroupThe Vanguard Group is an American investment management company based in Malvern, Pennsylvania, that manages approximately $1.6 trillion in assets. It offers mutual funds and other financial products and services to individual and institutional investors in the United States and abroad. Founder...
500 Index Fund charges 0.18% per annum.- 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.
- The 2 to 2.5% of additional returns that come from fundamentally based indices 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.
External links
- Research Affiliates Fundamental Index Strategy
- Fundamentally based index profile via Wikinvest