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As fundamental indexing has gained a foothold in the consciousness of investors, there have been critiques of the theoretical underpinnings of the concept. Today, I would like to offer a trader’s view of fundamental indexing.

How fundamental indexing works
Here is how fundamental indexing works. Instead of weighting a portfolio by market capitalization, you weight it by some fundamental measure (e.g. sales, book value, etc.). In practice, fundamental indices are weighted by a combination of fundamental factors, rather than a single factor, in order to increase stability.

There is an important difference between cap weighted indices and fundamentally weighted indices. Cap weighted indices are far more passive. In the absence of membership changes and changes in shares outstanding because of buybacks or new issues, a cap weighted index portfolio requires no trading or portfolio rebalancing, other than the periodic re-investment of dividends.

By contrast, fundamental indices need to be periodically re-weighted and rebalanced. As stock prices move over time, the actual weight in a fundamentally weighted portfolio will deviate from the target fundamental weight. In practice, the rebalancing occurs annually.

The perils of rebalancing
Years ago, I was involved in the management of an international equity portfolio benchmarked to a GDP weighted EAFE index (NYSEARCA:EFA). The GDP weighting was conceptually appealing to investors at the time because Japan was such a large weight in the cap-weighted EAFE index. Virtually no manager was at cap weight in the EAFE portfolio because it would leave the portfolio with too much country-specific risk. In practice, problems occurred on an annual basis when MSCI rebalanced the GDP-weighted EAFE index to its GDP weight. Japan’s weight in the index would typically move overnight by 5-10%. Such huge swings in the benchmark made it very difficult for an active, never mind passive, manager to run the portfolio.

An invitation for front-running
Any trader will tell you that the worst place to be as a trader is where the rest of the world knows what you have to do – and you have to do it despite that knowledge. This foreknowledge exacerbated the effects of the market crash of 1987 as market makers knew the portfolio insurers/program traders needed to sell more stocks as the market moved down. It also played a part in the sinking of Long Term Capital Management. The Street knew LTCM’s book. They knew the firm was in trouble. Arbs were front-running the firm’s positions, which worsened their losses.

As fundamental indexing gains in popularity, arbitrageurs, hedge funds and position traders can estimate the amount of rebalancing that will need to be done by the fundamental indexers – and front run them. This form of front running is not illegal, just smart trading, and it will serve to reduce the returns to fundamental indexing.

Investing in semi-passive investment strategies such as fundamental indexing is a game of inches. As fundamental indexing becomes more popular, rebalancing and implementation costs could easily take away any gains from the underlying investment concept.

Source: Investing in Fundamental Indexing: A Game of Inches