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What is Fundamental Indexing?
By JLP | November 14, 2006
When most people hear the word “index,” they most likely think about the Standard & Poors 500 Index. The S& P 500 Index is a market cap-weighted index. That means that the companies with the biggest market values make up the biggest percentage of the index. For those of you who don’t know, “market value” is computed by taking a company’s outstanding shares of stock and multiplying them by the current stock price. According to Robert Arnott in this interview in Investment Advisor Magazine, the flaw with this type of index is that it becomes overweighted with overvalued companies and underweighted with undervalued companies.
I never really thought about it like that but it makes sense. Arnott is a proponent of fundamental indexing, which uses a company’s fundamentals: sales, profits, book value, and dividends to determine its weighting in an index. According to the article, here’s how it works:
We look at a company’s sales, profits, book value, and dividends. If a company is 4% of the economy by sales, 3% by book value and profits, and 2% by the dividends that it pays, then, we could argue is it 2% or 3% or 4% of the economy or we could just take the average, and say “It’s about 3% of the economy and therefore it will be 3% of our index.” We simply equal-weight the four measures; if a company has never paid a dividend we just weight the other three—we don’t want to saddle a company with zero weight for dividends. It’s a simple process and that’s what makes it doubly amazing that it hadn’t been explored decades ago.
This sounds a lot like value investing on a very large scale.
Arnott’s company, Research Affiliates, now has 37 fundamental indexes published by FTSE. They are called the FTSE/RAFI Indexes. In addition, PowerShares now offers the FTSE RAFI US 1500 Small-Mid Portfolio and the FTSE RAFI US 1000 Porfolio, both of which are exchange-traded funds. PIMCO has also started offering a mutual fund called the Fundamental Index PLUS TR (a load fund).
In addition to the RAFI fundamental indexes, there’s also the ETFs offered by Wisdom Tree. Wisdom Tree has been in the news a lot lately. I’m sure a huge contributing factor to this is that they have author Jeremy Seigel as part of their company. Professor Seigel has developed a huge following after the publication of his book, Stocks for the Long Run
Finally, I must mention that not everyone is a fan of fundamental indexing. In fact, one well-respected indexer, John Bogle, wrote an op-ed piece with Burton Malkiel that was not favorable of fundamental indexing.
Who’s right? Which indexing method is superior? I guess time will give us that answer.
RELATED: Here’s a listing of all the ETFs offered by Wisdom Tree to date:
DOMESTIC ETFs
Total Dividend Fund (DTD)
LargeCap Dividend Fund (DLN)
MidCap Dividend Fund (DON)
SmallCap Dividend Fund (DES)
High-Yielding Equity Fund (DHS)
Dividend Top 100 Fund (DTN)
INTERNATIONAL ETFs
DIEFA Fund (DWM)
DIEFA High-Yielding Equity Fund (DTH)
International LargeCap Dividend Fund (DOL)
International MidCap Dividend Fund (DIM)
International SmallCap Dividend Fund (DLS)
International Dividend Top 100 Fund (DOO)
Europe Total Dividend Fund (DEB)
Europe SmallCap Dividend Fund (DFE)
Europe High-Yielding Equity Fund (DEW)
Pacific ex-Japan Total Dividend Fund (DND)
Pacific ex-Japan High-Yielding Equity Fund (DNH)
Japan Total Dividend Fund (DXJ)
Japan High-Yielding Equity Fund (DNL)
Japan SmallCap Dividend Fund (DFJ)
INTERNATIONAL SECTOR ETFs
International Basic Materials Sector Fund (DBN)
International Communications Sector Fund (DGG)
International Consumer Cyclical Sector Fund (DPC)
International Consumer Non-Cyclical Fund (DPN)
International Energy Sector Fund (DKA)
International Financial Sector Fund (DRF)
International Health Care Sector Fund (DBR)
International Industrial Sector (DDI)
International Technology Sector Fund (DBT)
International Utilities Sector Fund (DBU)
Topics: Exchange-Traded Funds, Index Funds, Investing, Mutual Funds |
November 14th, 2006 at 1:57 pm
Nice take on that article. I read the interview in my issue this weekend as well and was going to comment on it, but I think you hit on most of the key points. I agree it does sound a lot like value investing, which leads me to believe that if value continues to hold up well to growth, fundamental indexing will likely show slightly better returns over a traditional index.
November 14th, 2006 at 2:37 pm
I agree that index investing should be on a larger scale than the S&P index. Like Russell 5000 index is much more worth it(in my eyes vs. the much smaller S&P). Index investing needs to be in sectors of the market that requires a lot more education such as the Russell, or FTSE. Just my take though!
November 14th, 2006 at 3:37 pm
This is a great discussion as many asset managers are leaning more towards fundamental-weighting. I feel strongly that this trend will continue going forward. Jeremy Siegel, the Wharton professor, has been a big proponent of fundamental indexing for years. His primary reason is that the efficient market hypothesis (assumption that all stock prices are fairly valued) is more or less untrue. We’ve seen fundamentally-weighted indexes outperforming market-cap indexes for years now. This is partly because they give small-cap stocks a fair chance in the index rather than a miniscule weighting in the face of stocks like Microsoft. Siegel actually advises an ETF platform (WisdomTree Investments) which runs a full line of fundamentally-weighted, dividend-paying ETFs. Very interesting product…
November 14th, 2006 at 10:47 pm
Does this mean you always end with the dregs of the market, because you dump high flyers just as they start to fly?
Given the vast ocean of market data available, this sort of thing should be easy to prove or disprove objectively. It shouldn’t need to be “debated” - just run the index against existing data sets and see how it does. If it needs to be debated in some fancy theoretical way, it isn’t an index anymore…
November 15th, 2006 at 11:07 am
Cap weighting is not a “flaw” in the index. Cap weigthing means that all the stocks are automatically held at the correct weights, with no trading needed to rebalance. The first index fund (circa 1976) was equal weighted, and suffered from costs similar to actively traded funds.
November 15th, 2006 at 11:10 am
rmark,
I haven’t done the research but I would be interested to know what kind of turnover a fundamental index experiences each year.
November 15th, 2006 at 11:27 am
From the snippet above, they intend to use a simple value formula (so minimal research cost), and if they can keep turnover down they can avoid high trading costs (and taxes on the investor). Since ther aren’t tied to a traditional index, they don’t have to rebalance to match it.
Basically they have to buy and hold. But will investors stay when growth stocks are on a roll?
November 15th, 2006 at 11:30 am
Since these are likely higher dividend stocks, the taxes the investor pays may offset the funds hypothetical advantage. I don’t know either at this point.
November 15th, 2006 at 12:54 pm
I have posted the research papers making the case for “fundamental” indexing:
A Fundamental Indexing Reader
Counterarguments against this methodology are made by Bill Bernstein of Efficient Frontier is his essay, Fundamenta l Indexing; and by John Bogle (among other topics) in Whats ’s Happened to the Mutual Fund Industry?
Future performance will help answer questions of implementation costs, tax efficiency, as well as performance vis-a-vis appropriate factor weighted benchmarks.
November 17th, 2006 at 6:22 am
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