Should investors consider fundamentally weighted strategies?
Market-cap weighting reflects all market participants’ views, allowing passive investors a free ride on the collective wisdom of all active investors. But there is a risk that it could also lead a portfolio to overweight the most expensive areas of the market.
Fundamental index funds attempt to circumvent this potential problem by severing the link between a stock’s portfolio weight and its price. This article explores the investment thesis of fundamental weighting and examines the investment merits of strategies that use this weighting approach.
Market-cap-weighted indexes are inherently efficient and inexpensive to implement. A stock’s weight in a market-cap-weighted index moves with its share price. Investors save on transaction costs because the index’s largest positions are naturally the biggest companies with the most-liquid shares.
Unlike market-cap-weighted indexes, fundamental indexes size their holdings by metrics such as company revenue, earnings, or dividends instead of share prices. ‘Fundamental’ here is a bit of a misnomer because these metrics are only ‘fundamental’ in that they’re usually metrics that traditional fundamental stock-pickers use to evaluate companies.
But because fundamental indexes use the absolute level (such as total revenue) rather than a price-relative ratio (such as price/sales) to size positions, fundamental indexes maintain a similar large-cap orientation to market-cap-weighted indexes, while breaking the link to share price. The largest companies generally have the most revenue/earnings/dividends and receive the largest weightings in the index. Fundamental indexing is an intuitive weighting approach, but what does it really bring to the table?
Value and Size Rebranded?
The primary argument against fundamental indexing is that it is simply a value strategy repackaged as something new. Most of the time when a portfolio deviates from market-cap weighting, the alternatively weighted portfolio increases the weight of smaller-cap stocks and decreases the weightings of larger-cap stocks. The value tilt inherent to fundamental indexing stems from two sources. First, by weighting its holdings by a fundamental metric (such as revenue), the strategy overweights stocks trading at a lower multiple of that metric. Second, when the strategy rebalances, it trims stocks that have increased in price relative to that metric and adds to those names that lagged the market relative to the fundamental metric. While this weighting approach favors value stocks, it has less consistent exposure to value than market-cap-weighted value index alternatives because it does not explicitly target value stocks.
In a paper titled “Why Fundamental Indexation Might—or Might Not—Work”, Morningstar’s Paul Kaplan highlights that fundamental indexing implicitly assumes that all companies should trade at the same valuation multiples. Efficient market supporters counter that stocks should, and empirically do, trade at different multiples based on their risk and growth profiles. Kaplan also asserts that without knowing a stock’s fair value or fair valuation multiple beforehand, it is impossible to conclude in advance that a stock's current market price is too high or low, and whether stocks that command high valuations are overpriced.
Size and Value Everywhere
Several suites of fundamentally weighted exchange-traded funds have nearly a decade of live performance data. WisdomTree offers both dividend- and earnings-weighted ETF suites for large-, mid-, and small-cap market segments. Oppenheimer provides ETFs that weight their holdings by revenue. And PowerShares (and more recently Schwab) offers fundamentally weighted ETFs that leverage Research Affiliates’ RAFI indexes. The RAFI indexes combine several fundamental metrics such as cash flows, revenue, and dividends rather than a single metric to weight its holdings. Exhibit 1 provides a summary of the fundamentally weighted ETFs that I’ll examine more closely.