A Guide To Fundamental ETFs

by: SA Editors

What Are They?

  • Fundamental Indexes were pioneered by Rob Arnott. He argued that by giving greater weight to companies with larger market values, traditional indexes over-represent overvalued stocks, because the higher a stock's valuation the higher its market cap. He suggested an alternative: weight companies in an index based on fundamental factors other than market cap.
  • Mixed Fundamental Index ETFs weight stocks based on the following fundamental criteria: book value, cash flow, sales and dividends. The earnings and revenue ETFs rank stocks on those criteria alone.
  • Fundamental Index ETFs may be similar to Quant Strategy ETFs. The difference is that Quant Strategy ETFs may mix in techical factors, may not reveal the underlying rules to investors, and typically hold a limited number of stock. In contrast, Fundamental Index ETFs tend to hold all the stocks in an index, but ascribe different weightings to them based on fundamental criteria.

Why & How To Use Them

  • Use these ETFs instead of other broad index ETFs if you believe that fundamental indexes will outperform market cap weighted or equal cap weighted indexes. See Further Reading below.

What to Look Out For

  • Compared to traditional index ETFs, specialty ETFs such as fundamental index ETFs tend to have higher expense ratios and wider buy-sell spreads (which makes them more costly to purchase and sell).
  • A key advantage of ETFs based on market cap weighted indexes is that they do not have to buy or sell stocks due to fluctuations in stock prices, because changes in stock prices lead to changes in market cap. In contrast, ETFs based on non-market cap weighted indexes such as Fundamental Index ETFs have to buy and sell stocks as prices fluctate, typically by periodic rebalancing. That leads to higher portfolio turnover, resulting in potentially higher trading costs and lower tax efficiency.
  • It's harder to build a diversified portfolio if you don't know which stocks your ETFs contain, as that opens the possibility of overlapping holdings between ETFs. Traditional market cap weighted index ETFs are easier to manage.

Further Reading

This page is part of The Seeking Alpha ETF Selector which sorts ETFs by type, highlights how to use them and what to look out for, and provides links to articles that discuss key issues for investors.