Fundamental indexing

What Is Fundamental Indexing?

Fundamental indexing is an investment strategy within the broader field of portfolio theory that constructs an index fund by weighting its constituent securities based on fundamental measures of company size rather than their market capitalization. This approach aims to avoid the potential pitfalls of traditional cap-weighted indexes, which allocate more weight to companies simply because their stock prices have risen, potentially over-weighting overvalued assets. Instead, fundamental indexing uses metrics such as sales, earnings, book value, and dividends to determine the proportion of each company in the portfolio. The goal of fundamental indexing is to provide broad market exposure while incorporating a valuation-aware or "value" tilt.

History and Origin

The concept of fundamental indexing was popularized by Robert Arnott and his firm, Research Affiliates, in the early 2000s. Arnott, a prominent figure in quantitative finance, argued that traditional market-capitalization-weighted indexes inherently overemphasize overpriced stocks and underemphasize undervalued ones, leading to a long-term drag on performance. He proposed an alternative method that would break the link between a company's market price and its weight in an index. The "Fundamental Index™" strategy, which weights securities by measures like sales, cash flow, dividends plus buybacks, and book value, was launched in 2005. A¹²rnott's work challenged the conventional wisdom of passive investing and introduced what later became known as a form of smart beta investing.

¹⁰, ¹¹## Key Takeaways

• Fundamental indexing weights companies based on economic measures like sales, earnings, book value, and dividends, rather than stock price.
• This approach aims to mitigate the risk of over-allocating to potentially overvalued stocks that can occur in market-capitalization-weighted indexes.
• It is considered a rules-based, transparent approach that bridges elements of passive investing and active management.
• Proponents suggest fundamental indexing may offer the potential for enhanced risk-adjusted return over the long term, particularly during periods when value stocks outperform.
• Implementing fundamental indexing typically involves higher portfolio turnover and associated costs compared to traditional cap-weighted indexes due to regular rebalancing.

Formula and Calculation

Unlike a simple financial ratio, fundamental indexing does not rely on a single, universal formula but rather a methodology for weighting securities within an index. The core idea is to determine a company's "economic footprint" or intrinsic size using various fundamental financial data points.

The weighting for each company in a fundamental index is typically calculated as follows:

1. Select a basket of fundamental measures: Common measures include average sales, average cash flow, average dividends plus buybacks, and average book value, often averaged over a period (e.g., five years) to smooth out short-term fluctuations.
2. Calculate the fundamental weight for each company: Each company's weight in the index is proportional to its share of the total fundamental value of all companies in the index. For example, if a company represents 2% of the total aggregate sales of all companies in the index, it would be assigned a 2% weight based on sales.
3. Combine individual factor weights: If multiple fundamental factors are used, their individual weights may be averaged or combined in a specific formula to arrive at a composite fundamental weight for each company.

For example, using a simplified approach with four factors:

Where:

• (\text{Fundamental Weight}_i) = The weight of company i in the fundamental index.
• (\text{Sales}_i), (\text{Earnings}_i), (\text{Book Value}_i), (\text{Dividends}_i) = The fundamental measure for company i.
• (\sum \text{Sales}), (\sum \text{Earnings}), (\sum \text{Book Value}), (\sum \text{Dividends}) = The sum of that fundamental measure for all companies in the index.

This calculation ensures that companies with larger fundamental values receive a greater allocation, irrespective of temporary fluctuations in their stock price. This methodology stands in contrast to approaches that may overweight growth stocks that have experienced significant price appreciation.

Interpreting Fundamental Indexing

Interpreting fundamental indexing involves understanding its underlying philosophy: that a company's true economic size and value are better reflected by its fundamentals than by its stock price alone. When applied, fundamental indexing tends to overweight companies that are larger by economic metrics but may be currently undervalued by the market, and underweight those that are smaller fundamentally but whose prices have soared. This often results in a tilt towards value investing characteristics.

A portfolio employing fundamental indexing is interpreted as seeking to capture potential long-term returns by systematically investing more in companies with robust underlying businesses relative to their market valuation. It implicitly benefits from the tendency of market prices to revert to fundamental values over time. Investors evaluate a fundamental index based on its ability to generate competitive long-term returns with potentially lower volatility compared to market-cap-weighted alternatives, considering its active bets against market prices.

Hypothetical Example

Consider a hypothetical index of three companies: Alpha Corp, Beta Inc, and Gamma Ltd.

Traditional Market-Cap Weighting:

In this market-cap-weighted index, Alpha Corp, despite having a relatively smaller fundamental footprint (as we will see), dominates the index due to its high share price.

Fundamental Indexing:

Now, let's consider the same companies, but weighted by their average annual sales over the past five years:

In the fundamental index, Gamma Ltd, with the largest average sales, receives the highest weight, even though its market capitalization was not the largest in the prior example. This scenario illustrates how fundamental indexing could lead to a different portfolio construction and asset allocation than a market-cap-weighted approach, potentially favoring companies that are economically significant but perhaps not currently favored by market sentiment.

Practical Applications

Fundamental indexing is primarily applied in the creation of passively managed investment products, particularly exchange-traded funds (ETFs) and mutual funds. These funds aim to replicate the performance of a fundamental index. Institutional investors, such as pension funds and endowments, as well as individual investors, use fundamental index funds to gain broad market exposure while seeking to potentially enhance returns or reduce risk compared to traditional market-cap-weighted indexes.

For example, large asset managers license fundamental indexing methodologies from firms like Research Affiliates to offer a range of products to their clients. As of 2015, licensees of the Research Affiliates Fundamental Index (RAFI) methodology managed approximately $140 billion in assets, illustrating its adoption in the investment community. T⁹his strategy is often considered by investors looking to diversify their index exposure beyond just market capitalization.

Limitations and Criticisms

Despite its appeal, fundamental indexing has faced several limitations and criticisms:

One common critique is that the perceived outperformance of fundamental indexes over market-cap-weighted indexes can often be attributed to their implicit tilts towards specific investment factors, primarily size and value. Critics argue that fundamental indexing is not a distinct factor but rather a repackaging of these well-known factor exposures. I⁷, ⁸f the market environment favors large-cap or growth stocks, fundamental indexing, with its value and potentially small-cap tilt, might underperform.

Another limitation is the increased portfolio turnover inherent in fundamental indexing. Because weights are based on fundamental measures that may not change in lockstep with market prices, the index often requires more frequent rebalancing to maintain its target weights. This can lead to higher transaction costs and potentially greater tax inefficiencies in taxable accounts compared to cap-weighted indexes, which naturally rebalance as prices change.

⁵, ⁶Furthermore, while proponents suggest long-term benefits, live performance data for fundamental index funds, particularly over very extended periods, is less extensive than for traditional market-cap-weighted funds. Early performance expectations from back-tested data have sometimes exceeded actual returns. P⁴aul Kaplan of Morningstar has highlighted that assuming all companies should trade at the same valuation multiples, as fundamental indexing implicitly does, is debatable, as efficient markets suggest different multiples based on risk and growth profiles.

³## Fundamental Indexing vs. Market-Cap Weighting

The primary distinction between fundamental indexing and market-cap weighting lies in how securities are weighted within an index. Market-cap-weighted indexes, such as the S&P 500, assign weights based on a company's total market value (share price multiplied by shares outstanding). This means that companies with higher stock prices, regardless of their underlying financial health or economic footprint, exert a greater influence on the index's performance. The rationale for market-cap weighting is that it represents the aggregate market's collective judgment of a company's value and is highly liquid and low-cost to replicate.

²Conversely, fundamental indexing explicitly disconnects a company's weight from its stock price. By using measures like sales, earnings, book value, and dividends, fundamental indexing aims to allocate more capital to companies that are larger in terms of real economic activity, potentially identifying those that are undervalued by the market. This approach introduces a "value" bias, as it tends to underweight companies whose stock prices have become inflated relative to their fundamentals and overweight those whose prices may be depressed relative to their underlying economic strength. W¹hile market-cap weighting is often seen as a purely passive reflection of the market, fundamental indexing incorporates a rules-based, active decision regarding company valuation, leading to different portfolio characteristics and potential performance drivers.

FAQs

Q: Is fundamental indexing a form of active or passive investing?
A: Fundamental indexing is generally considered a rules-based, passive strategy in terms of its implementation, as it follows predefined rules without discretionary stock picking. However, its method of weighting based on fundamental factors, rather than market price, gives it characteristics often associated with active management, such as a value tilt.

Q: How does fundamental indexing aim to improve returns?
A: Fundamental indexing aims to improve returns by systematically rebalancing away from potentially overvalued stocks (whose prices have risen disproportionately to their fundamentals) and towards undervalued stocks (whose prices have lagged their fundamentals). This contrarian approach seeks to profit from the mean reversion of stock prices to their intrinsic values.

Q: What are the main fundamental metrics used in fundamental indexing?
A: The main fundamental metrics typically used in fundamental indexing include sales, earnings, book value, and dividends (or dividends plus buybacks). These are often averaged over several years to provide a more stable measure of a company's economic size.

Q: Are fundamental index funds more expensive than market-cap-weighted index funds?
A: Generally, fundamental index funds tend to have slightly higher expense ratios and potentially higher trading costs due to more frequent rebalancing compared to market-cap-weighted funds. This is because their weighting scheme often requires adjustments as companies' fundamental measures change or deviate from their target weights.