The birth of fundamentally-weighted exchange traded funds (ETFs) came from a group of investors who believe that market-cap indexing is inefficient. Though market-cap weighting has its merits, fundamentally-weighted ETFs take into account far more than other more traditional forms of indexing.

The Origins

“Fundamental Indexation,” a study in 2005 conducted by Rob Arnott, Jason Hsu and Phillip Moore, argued that fundamentally indexed portfolios outperformed the S&P 500, which uses a cap-weighted methodology, by 2% per year over the 43 years examined in the study. That 2% adds up to a hefty sum over decades of investing.

So with that, the group of investment experts gathered around the idea of an alternative to cap-weighted indexes: fundamentally weighted indexes.

What It Is

Fundamental indexing chooses index components by examining their fundamentals – not just market-capitalization. Some factors that have been considered in fundamentally-weighted indexes include things like book value, cash flow, revenue, sales and dividends.

The FTSE RAFI 1000 is a fundamentally-weighted index that includes 1,000 components based on a rules-based model that factors in sales, cash flow, book value and dividends. The fundamental index selects and weights component stocks based on current and quantitative ranking of company data.

The Benefits of Fundamental Indexing

The primary argument for fundamentally-weighted indexes is that the price of a stock won’t reflect the true underlying value of a company. For instance, speculators, momentum traders, hedge funds and institutions that trade on a company for reasons unrelated to the underlying fundamentals, such as tax purposes, would influence the price of a stock. These external factors could skew the price of a stock for a prolonged period, creating movements in a stock’s price that can’t necessarily be predicted by looking solely at market cap.

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