Disclosure: I work for a company that provides Fundamental Index® mutual funds in the Canadian marketplace.
The S&P/TSX Composite Index, the S&P 500 index and other major benchmark indexes around the world are “market capitalization weighted”. This means that the weight of any constituent stock is determined by its market capitalization versus the total market capitalization of all stocks in the index. For example, if an index had a total market cap of $100 billion and stock A had a market cap of $5 billion, Stock A would have a 5% weighting in that index.
A Fundamental Index uses fundamental factors to determine weightings, specifically the FTSE RAFI series uses free cash flow, book value, gross dividends and total sales. Note that these are not ratios (like price-to-book), these are price indifferent metrics. In other words, a Fundamental Index weights companies using fundamental factors to determine weightings in its index.
As long as:
1. There are mispricings in the market (stocks get overpriced and underpriced)
and
2. Active managers exist and serve to eventually identify these mispricings and therefore bring them closer to fair values (they buy underpriced companies, they sell overpriced companies)
then a Fundamental Index will outperform a market cap weighted index over longer periods of time.
This is because a cap weighted portfolio will assign more and more weight to a stock as it gets overpriced. Therefore once it is identified by the market as too expensive, more of your portfolio will decrease. Vice versa, as a stock is beaten up, a cap weighted portfolio will assign less and less weight to that stock. Once the market has identified this and brings the price back up a cap weighted portfolio is underexposed to this stock which is increasing in value.
This manifests into a long term outperformance of a Fundamental Index versus a cap weighted index.
There are other considerations: a Fundamental Index will have slightly higher turnover, and slightly higher costs. But personally, I am not invested in any cap-weighted index funds if there is a Fundamental Index fund alternative.
Ah… Not quite. You forgot criterion number three: that the particular fundamental index you’ve chosen is a better guess of intrinsic value than market cap. Without this, #1 and #2 are not sufficient to cause your fundamental index to outperform.
“Let’s assume we have a new hypothetical index with only four companies in it. Each company has $1 of earnings, but two have growth prospects to justify a 20 times P/E (meaning the price should be $20) and the other two have growth prospects to justify a 10 times P/E (meaning their price should be $10). We know that the market will just guess at these values, but let’s assume these are the correct values (or the fair values).
If the market does a “pretty good” job at guessing the fair value, it might be off by 20% on average. Let’s assume that the market overprices one of the $10 stocks and one of the $20 stocks, and that it underprices the other $10 stock and the other $20 stock. Therefore we have stock prices of $8, $12, $16, and $24.
In a cap-weighted portfolio, if the prices reverted to their fair prices, you have a zero percent return – the errors cancel. If you instead had a fair-value weighted index half the portfolio would rise 25% and the other half would lose 16.7% for a net return of 4.2%.
Harry Markowitz is quick to point out that we have no way of determining fair value, so why should we care that fair-value weighting beats cap-weighting? He answers himself: The index weighted by earnings gives you the exact same result of a 4.2% return. Each company earned $1, so each company would be weighted equally. As long as cap-weighting has errors relative to fair value and prices revert to fair value, cap-weighting will suffer a drag relative to fair-value weighting (or a proxy of such). Any portfolio that differs from fair value weighting in a manner that is uncorrelated with the error in price will match the return of a fair-value weighted portfolio.”
From an earlier blog post.
I don’t believe a fundamental index has to be a better guess of intrinsic value so much as it just doesn’t magnify overpricing errors and diminish underpriced stock weights. It’s a drag inherent to the cap-weighting methodology.
There is a third criterion, but I’m not sure how to phrase it. It is possible for market conditions to satisfy your first two criteria, but leave fundamental indexes underperforming. Suppose that the market always sets a price that is half-way between fair value and fundamental value (as defined by the fundamental index). As prices get pushed up or down toward fair value, a fundamental index will own more of stocks that are dropping and less of stocks that are rising than cap-weighted indexes will. So, fundamental indexes will lag.
Just to be clear, I don’t believe this is what happens in real markets. In reality, markets seem to frequently overreact. When this happens, it favours fundamental indexes. But my little example shows that there is some third criterion that isn’t too far from Patrick’s wording that the fundamental index must give a better guess of market cap.
I think the missing assumption may be that the total valuation of the index is correct (fair) and the pricing error is only in the relative prices. If you make this assumption, then the above might work.
However, I don’t think the following statement is true for a market cap weighted index:
“a cap weighted portfolio will assign more and more weight to a stock as it gets overpriced.”
This is only true if the stock in question is being overpriced (over fair value) relative to the other stocks in the index. If they’re all becoming overpriced (one example), then the statement isn’t true. Similarly, a stock can become overpriced without any change to its market cap (due to a change in its fair value).
Another way to think of it is to consider that the Fundamental index may be over-weighting the lower priced stocks and under-weighting the higher priced stocks. I think the other posters are saying the same sort of thing.
@Preet: It’s easy to come up with an index that neither magnifies overpricing errors nor diminishes underpriced stock weights. Just buy the under-priced stocks.
What? Not as easy as it sounds? :-)
Of the four factors listed, it sounds like two might have some risks. Having higher sales and book value for the same earnings as another company can be a sign of inefficiency. But as mentioned before if it gets you away from following the herd I guess it works.
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I’d like to know why RAFI / ProFinancial / Claymore / Powershares, etc haven’t come out with a fundamental bond index?
A 130/30…index works for me :)
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