Fundamental Indexing

Consider the purpose of a market index.  We use an index to define the value of the market, overall.  When we use a market index as a benchmark for any specific holding or portfolio, we need to be able to rely on that index as a reasonable measurement for what “the market” is worth at any given moment, and over time.  If you are an efficient market hypothesis believer, market capitalization weighting is the only accurate way to measure the economic value of any specified market.

But what if you think that at least some of the time, prices for individual companies, sectors, and even the whole market can diverge from their true economic value?  This premise is the basis of factor investing, “smart beta,” and behavioral investing.  Several “fundamental” weighting schemes have been developed to try to measure economic value in ways other than equity price.

Dividend discount model is a simple and common method of determining the economic value of a stock.  Free cash flow models based on earnings are also widely recognized.  WisdomTree has offered both dividends and earnings weighted funds for over 10 years.  Jeff Weniger offers a thorough explanation of the advantages of earnings weighting at and Jeremy Schwartz published a white paper in 2016 detailing dividend weighting,  Pacer US Cash Cows 100 Index selects and weights the largest 100 companies by free cash flow.  The associated ETF, COWZ, just opened in December 2016.  They describe their approach here:  Please note that this is a new index as well, so it really doesn’t have a track record other than backtesting.

Oppenheimer weights by top line revenue, as explained by David Mazza, The tech bubble is used as an example here.  You can see how at the height of the bubble, a minority of the stocks with increasing prices came to dominate the cap weighted index, but not so much the revenue weighted index.

Oppenheimer Revenue Weighting – graph from page 16 of Oppenheimer presentation – used with permission.

Rob Arnott (arguably the originator of fundamental weighting) and Research Affiliates (RAFI) have developed 3 unique indexes, which weight companies with varying combinations and definitions of sales, cash flow, dividends, and book value.   The FTSE RAFI US 1000 Index consists of the 1000 largest companies as calculated by their economic value, using a formula including total cash dividends, free cash flow, total sales, and book equity value.  Invesco, who sponsors the ETF for this index (PRF), shows the converse of the Oppenheimer example:  during the last crisis, the financial sector became under valued, and thus under weighted in the cap weighted index.

Invesco chart – used with permission.

Critics of the fundamental approach to indexing call it value investing by another name.  This is true by definition.  However, the difference between a value index and a fundamental index is that the fundamental index is not using the equity price in any form to determine inclusion or weight in the index.  A value index will always include some form of the price in its inclusion and/or weighting calculations, usually in a ratio (P/E, P/S, etc.).  The amount of value tilt changes over time for a fundamental index, while it is defined for a value index.  Issuers of fundamental indexes consider this a feature, not a bug.  The goal of the fundamental index is to represent the market constituents weighted by their economic value or economic impact, not to determine which equities or sectors are “incorrectly” priced.

What about performance?

As of 6/30/17 3 yr 5 yr 10 yr
YTD 1 yr 3 yr 5 yr 10 yr sd beta sd beta sd beta
S&P 500 TR Index 9.34 17.9 9.61 14.63 7.18 10.35 9.56 15.21
FTSE RAFI US 1000 Index 4.69 16.92 7.89 14.82 7.68 10.25 0.96 9.73 0.99 16.02 1.04
WisdomTree LargeCap Dividend Index 6.7 14.23 9.08 13.19 6.72 9.87 0.93 9.12 0.92 14.63 0.93
OFI Revenue Weighted Large Cap TR 7.41 16.49 8.7 15.55 7.29 10.38 0.98 9.9 1.01 16.51 1.07
WisdomTree US Earnings 500 Index 9.39 22.29 9.46 14.65 7.35 10.81 1.03 9.91 1.02 15.03 0.98
Pacer US 100 Cash Cows Index 6.74 23.15 9.02 16.98 10.32 13.46 1.2 12.41 1.2 19.83 1.21
Russell RAFI US Large Company Index 4.8 14.2 7.75 14.3 7.91 10.25 0.96 9.73 0.99 16.02 1.04
*Data from ETF providers and Morningstar

Please note that the outlier in this group, Pacer, reflects backtesting data prior to 2017.  The three year betas less then one suggest that the fundamental indexes are not performing as well as the S&P 500 over this portion of a bull market, and they are not.  A full market cycle would be the best way to evaluate performance.  The 10 year betas less than one might be what is expected – a dampening effect from removing the impact of excess pricing at market highs, and oversold equities at market lows. Another way to look at it would be that the market tends to overshoot at both extremes – the real economy is not moving as much.  But of the 6 indexes, only 2 reflect this theory.

What explains this?  The fundamental indexes are rebalanced quarterly or annually, while a cap weighted index self-rebalances on a continuous basis, other than adjustments for changes in listings and float. Rebalancing also adds trading costs as well as possible tax liabilities.  RAFI methodologies use 5 year averages of data, so they will be slower to respond to changes in issuer value than the cap weighted index.  The Oppenheimer and WisdomTree indexes are also capped by issuer and sector.  Similar to smart beta, it’s just more complicated to implement these strategies than cap weighted.

The ETFs based on fundamental indexes generally charge around .25% – .50%, while the cap weighted index ETF can be bought for .03%.  The 10 year returns net of fees are very similar to the cap weighted index.  Other cost considerations are size and trading cost of the ETFs, as well as tax implications. Obviously dividend weighted funds will have higher taxable income than cap weighted.

In summary, the theory of the fundamental index is quite compelling, but the current indexes somewhat less so. It seems likely that this reflects the difficulty in implementation rather than flaw in theory.

Disclosure:  I do not currently hold or plan to add any fundamental weight products for myself or clients.  Do have positions in cap weighted funds and ETFs.




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