The second level of fundamental indexing, known as enhanced or quantitative indexing, looks at a wider variety of factors that include fundamental, technical and sentiment-oriented characteristics (e.g. insider buying, put/call options activity).
If a stock’s price falls for reasons unrelated to the fundamentals, holds the fundamental-indexing theory, it is probable that overweighting the stock would create better returns while stocks that rise more than their fundamentals may be seen as overpriced stocks and likely to underperform the market.
Fundamental indexes have to be rebalanced periodically through purchasing more shares of companies that have devalued more than their fundamental metric and selling shares of companies that have risen in value above their fundamental metric.
Fundamentally-Weighted ETFs
As a result of rebalancing and their smaller size, ETFs that track fundamentally-weighted indexes may have higher costs than cap-weighted indexes.
Because fundamental indexing tends to tilt more toward value than growth, fundamentally-weighted indexes are better suited for investors who see value or income as the main factors that could contribute to companies outperforming the overall market.
Fundamentally-weighted ETFs are ideal for giving your clients exposure to such strategies. Examining the fundamentals of any corporation can be a time-consuming venture, but by buying a basket of them, you’ve let the ETF providers do the legwork.
There are a variety of ETFs that are based on fundamental indexing methods, including:
- PowerShares FTSE RAFI Developed Markets ex-U.S. Portfolio (NYSEArca: PXF)
- WisdomTree Earnings 500 (NYSEAca: EPS)
- RevenueShares Large Cap (NYSEArca: RWL)
The best way to find out whether an ETF is market-cap weighted or fundamental is to read the fund’s fact sheet. You can find this on the ETF Resume.