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.
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.