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Are Fundamentally Weighted Indexes a Better Mousetrap?

Jared Kizer, my Alternative Investments co-author, was recently asked whether fundamentally weighted indexes were superior to traditional, market-cap-weighted indexes. As I've been asked the question numerous times myself, I thought it would be helpful to share his thoughts.

Proponents of fundamentally weighted indexes continue to argue that this weighting approach is inherently superior to market capitalization weighting. However, there simply doesn't appear to be anything special per se with this weighting scheme.

Before we dig into our analysis, we wanted to discuss the differences in the two approaches. With fundamental weighting, the weight a stock receives in a portfolio -- meaning how much of the portfolio gets invested in a single stock -- is determined primarily by "fundamentals" such as the dividends the company pays, the accounting value of the company or some combination of factors of similar nature. For example, companies that pay higher dividends or have higher book values would typically receive a higher weight.

Market-cap weighting is much simpler. It weights the company according to the market value of the company's outstanding stock. (This value is frequently referred to as the company's market capitalization.) So companies with larger market capitalizations will receive larger weights. One of the advantages of this simpler approach is that there's no need to rebalance the portfolio (meaning sell some of stock A so that you can buy more of stock B) just because stock prices have changed. In a sense, rebalancing of a market capitalization weighted portfolio happens automatically.

The main critique we have of fundamentally weighted indexes is that they don't deliver anything that you can't achieve using passively managed market-capitalization weighted value funds, yet they're advertised as if they do. The best way to measure whether fundamentally weighted indexes truly deliver superior performance is analyzing whether the historical returns of fundamentally weighted indexes have been higher than expected after adjusting for the following three sources of higher equity returns:

Size Risk Historically, small-cap stocks have outperformed large-cap stocks by about 3.8 percent per year over the period of 1927-2010.

Value Risk Value stocks (stocks with low price-to-earnings ratios) have outperformed growth stocks (stocks with high P/Es) by about 4.9 percent per year.

Momentum Stocks that have done well in the recent past typically continue to do well over the next year. Stocks that have done poorly in the recent past typically continue to do poorly. This effect is called the momentum effect and has averaged about 9.7 percent per year.

The basic idea is that a strategy like fundamental indexing (or any other equity strategy) shouldn't get credit for delivering superior returns if the returns are explained by simple tilts toward small-cap stocks, value stocks or high momentum stocks. By analogy, a student doesn't receive a better grade on a test for writing her name and the date on the test because everyone can do that. She gets a better grade by answering questions that other students can't answer.

We examined the performance of the FTSE RAFI US 1000 Index over the period of January 1962 through July 2011 (the longest for which we have data). This is a fundamentally weighted index of large companies. We also analyzed the performance of the FTSE RAFI US 2000 Index over the period of January 1979 through July 2011 (again, the longest for which we have data). This index is a fundamentally weighted index of small companies.

After adjusting for the above three factors we found that the RAFI 1000 underperformed by about 0.20 percent per month. This result was highly statistically reliable, meaning that we have reason to believe it wasn't the result of dumb luck. The RAFI 2000 outperformed by about 0.05 percent per month, but this result wasn't statistically reliable and, of course, doesn't reflect trading costs or fund expenses. Of further note, both indexes had substantial exposure to negative momentum stocks, meaning stocks that have done poorly in the recent past and typically continue to do poorly. Intelligently constructed passively managed value funds can mitigate exposure to this effect.

To us, these results say about all that needs to be said about fundamentally weighted indexes. At the end of the day, they appear to be delivering nothing more than exposure to the value effect. In our opinion, passively managed market capitalization weighted value funds are a simpler and likely less costly way to obtain exposure to the value effect. Some of these funds also have the added advantages of providing more exposure to the value premium than the RAFI indexes as well as intelligent design to mitigate the effects of negative momentum stocks.

Photo courtesy of winnifredxoxo on Flickr.
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