It seems like a simple question, but it has sparked some of the most heated debate the index industry has seen in decades, complete with name-calling, threats of legal action and a knock ‘em out, drag ‘em out public brawl on the op-ed pages of The Wall Street Journal.
Morgan Stanley Global Wealth Management tackled the question in a new research report published on April 23 by Paul Mazzilli and Dominic Maister.
What Is “Fundamental” Indexing?
The idea behind fundamentally weighted indexes is to weight stocks in an index by some “fundamental” measure of value. Traditionally, most market indexes have been weighted by market capitalization; a few have used equal weighting methodologies; and the most famous market indicator, the Dow Jones Industrial Average, uses a price-weighting system. In general, however, stock market indexes tend to be market-cap-weighted.
Proponents of fundamental indexing argue that market-cap weighting overvalues the larger stocks and undervalues the smaller stocks, skewing the market. To capture the “true value of the market,” fundamental indexes weight components by dividends, book value, earnings or some other finance-driven metric or combination of metrics.
The Morgan Stanley study examines the performance of some of these fundamentally weighted indexes and similar market-cap weighted indexes. The report looks at select large-, mid- and small-cap indexes, as well as at broad market indexes, over the periods of 1-, 3-, 5-, 10- and 12-years. All of the indexes considered underlie corresponding exchange-traded funds (ETFs).
One argument regarding fundamental indexes is that they are skewed to favor value stocks. Because value stocks have dominated for most of the past decade, Mazzilli and Maister added a 12-year period to the study when possible, to see what would happen to the performance statistics if some more growth-dominated years were included.
What did the study find? Well, not surprisingly, it did show that most fundamentally weighted indexes are highly correlated both with each other and with traditional value indexes. However, the value tendency of fundamental indexes was not true across the board. Similarly, the study also undermined the assumption held by many that fundamental indexes are uniformly small-cap biased.
Large Cap Indexes
The large-cap indexes examined included the fundamentally weighted Wisdom Tree LargeCap Dividend Index (DLN), the Rydex S&P Equal Weight Index (RSP), and the FTSE RAFI U.S. 1000 Index (PRF). The WisdomTree index, weighted by dividend distributions, had the highest mean and median market cap of the three, while the FTSE RAFI U.S. 1000 and the S&P Equal Weight index skewed lower.
The performance turned out just about how you would expect for the value-friendly period studied. The study compared the performance of the fundamental indexes against the cap-weighted S&P 500 (IVV) and S&P/Citicorp 500 Growth (IVW) and Value (IVE) indexes. Over the 12-year period, the three fundamental indexes all outperformed the S&P 500, with its 11.8 percent return. However, when growth outperformed value, all three indexes trailed the S&P 500.
In the mid-cap segment, the WisdomTree MidCap Dividend Index (DON) was measured against the S&P MidCap 400 (IJH) and the S&P MidCap 400/Citigroup Growth (IJK) and Value indexes (IJJ). The WisdomTree MidCap Dividend Index has the highest mean and median market cap of the four indexes.
The WisdomTree MidCap Dividend Index shows one of the key things that investors should understand about fundamentally weighted indexes: they can have significantly different holdings from their market-cap weighted peers. In this case, nearly half of the WisdomTree index (46 percent) was focused in Financials, compared to just 16 percent for the S&P MidCap 400
For the 10-year period ending in 2006, the S&P MidCap 400/Citigroup Growth Index had the highest return of the four indexes in the group at 15.5 percent, followed by the WisdomTree MidCap Dividend Index at 13.8 percent. During this time period, the WisdomTree index also showed the highest Sharpe ratio, at 0.07, and, as a result, the highest rate of risk-adjusted return in the group.
Value out performed growth in 6 of the 10 years examined, indicating that the period was value-dominated. Indeed, the WisdomTree index returned 16.5 percent in the value-dominated 2000-2006 time period, easily outperforming the S&P MidCap 400/Citigroup Value, the S&P MidCap 400, and the S&P MidCap 400/Citigroup Growth indexes, which delivered 11.8 percent, 10.1 percent and 8.3 percent, respectively. However, in the growth-dominated time period of 1996-1999, the WisdomTree MidCap Index was the worst performer in the group, returning only 8.5 percent --- just slightly more than half of the S&P MidCap 400/Citgroup Growth Index’s 16.6 percent return.
Small Cap Indexes
The Zacks PowerShares Small Cap Index (PZJ) and WisdomTree SmallCap Dividend Index (DES) were measured against the S&P SmallCap 600 Index (IJR) and the S&P SmallCap 600/Citigroup Growth (IJT) and Value (IJS) Indexes. The WisdomTree index had the smallest mean and median market cap of the group, although the Zacks index’s mean and median were still smaller than those of the S&P SmallCap 600. In terms of performance, the WisdomTree SmallCap Dividend Index was the best performer for the value-dominated 10-year period ended 2006; it was also the winner during the value-specific stretch from 2000-2006.
During the 2000-2006 period, the Zacks PowerShares Small Cap Index was the poorest performer, with an average annual return of only 9.1 percent. However, during the growth years of 1998-1999, the Zacks PowerShares Small Cap Index easily surpassed the other indexes, delivering 15.6 percent returns compared to 9.4 percent for the S&P SmallCap 600/Citigroup Growth index and just 3.9 percent for the WisdomTree SmallCap index returned -3.9%. While the Zacks index correlated strongly with the three S&P indexes, its correlation with the WisdomTree index was just 0.74, and it clearly did not share the value bias broadly attributed to fundamental indexes.
Finally, two broad-market indexes, the WisdomTree Dividend Index (DTD) and the Dynamic Market Intellidex Index (PWC), were measured against the Russell 3000 (IWV) and the Russell 3000 Value (IWW) and Growth (IWZ) indexes. According to the report, the mean and median market cap for the two fundamental indexes were much higher than for the three Russell indexes, at least in part because they contained far fewer stocks.
In terms of performance, the two fundamental indexes outperformed the various Russell indexes for the 12-year period ending 2006. WisdomTree and Dynamic Market indexes returned 14.2 percent and 14.3 percent, respectively, for the 12-year period ended 2006, outperforming the Russell indexes. During the growth-dominated time period of 1996-1999, however, when the Russell 3000 Growth Index returned 29.8 percent, the Dynamic Market index returned only 19.1 percent and the WisdomTree index returned only 17.2 percent. In the value-tilted years of 2000-2006, the WisdomTree index was the best performer with a 9.4 percent return, followed by the Dynamic Market index with a 9 percent return. Both outperformed the Russell 3000 Value Index with its 8.4 percent return, and the Russell 3000 Index with its 2 percent return.
In short, the study worked out like this: during periods where value outperformed, the fundamentally weighted indexes beat market-cap benchmarks; during periods where growth outperformed, they trailed. The fundamental indexes may not be just value indexes, but they are certainly correlated with value-based outperformance.