Financial Analysts Journal
In that issue, an article titled "Fundamental Indexation" laid out a compelling alternative to the standard formula for creating an index; instead of assigning index members a particular weight based upon their market capitalization, indexes could be weighted according to one or more other "fundamental" metrics, such as their earnings, dividends, cash flow, book value, revenue or even the number of employees. The publication was timely–surging demand for exchange traded funds was encouraging ETF sponsors to look for innovative indexes on which to base new products. By the end of 2005, the PowerShares FTSE RAFI US 1000 Portfolio–the first ETF tracking a fundamentally weighted index–was already up and running.
Since then, ETF sponsors have created roughly two dozen other ETFs tracking fundamentally weighted indexes. In addition to PowerShares, WisdomTree and RevenueShares also offer ETFs that track fundamentally weighted indexes. Most fundamentally weighted ETFs target U.S. equities, though there are several foreign equity funds as well. Research Affiliates, a Newport Beach, California-based company founded by Rob Arnott–one of the article's authors and the leading proponent of fundamental weighting–estimates more than $50 billion in assets currently managed using fundamental indexation strategies.
Interest in fundamental indexation appears to be increasing. PowerShares announced in August 2010 that it restructured its High Yield Corporate Bond Portfolio to track a fundamentally weighted index, the first fixed income ETF to do so. Research Affiliates said in July it is teaming up with Tacoma, Washington-based Russell Investments – publisher of market cap weighted indexes–to create a new index series based on fundamental metrics.
Arnott and other advocates for fundamentally weighted indexes argue that they correct a serious defect in market capitalization weighted indexes that tends to cause poor performance. See WealthManagerWeb.com's exclusive interview with Arnott in, "A Better Way to Invest in Bonds?" By giving the largest allocations to the companies with the largest market capitalizations, they say, investors are buying more shares in the market's most overvalued companies, and comparatively fewer shares in the market's most undervalued companies, exactly what they don't want to do. " This mismatch leads to a natural performance drag in cap-weighted and other price-weighted portfolios," the article says.
While acknowledging that fundamentally weighted indexes have their own shortcomings–they do not produce "market aggregate" returns as cap-weighted indexes do and they tend to offer better relative returns in bear rather than bull markets–Arnott argues that overall, they simply perform better. Using data from the 43 years between 1962 and 2004, the article finds that fundamentally weighted indexes beat the cap-weighted Standard & Poor's 500 by an average of 1.97% annually–enough to more the double aggregate returns over the time period. "Noncapitalization-based indexes consistently provide higher returns and lower risks than the traditional cap-weighted equity market indexes while retaining many of the benefits of traditional indexing," Arnott and his co-authors declare in the article.
