Why Fundamental Indexes Lagged Cap-Weighted in '07

Includes: PRF, PRFZ, SPY
by: Roger Nusbaum

IndexUniverse has an article up that recaps 2007. It notes that fundamental indexing like the RAFI ETF (NYSEARCA:PRF) and some of the WisdomTree funds lagged the cap weighted funds. This was more of a domestic (rather than foreign) phenomenon.

The article even quotes Bruce Lavine from WisdomTree offering some explanation. The article attributes the following quote to Lavine: "There are some unique characteristics about the U.S. market that have just been tough this year. That had to do with getting let down by companies that had solid fundamentals on paper."

The article concludes that it does not really mean much as it is just one year, and the author posits that subprime could be to blame.

I don't think the article looks at quite the right thing, and I would say there is not enough of a look forward.

Most of what happened with domestic fundamental indexing can be explained with a this-is-how-the-market-works analysis. If you read any of my TSCM articles (here's one from August, 2006) about any of the broad based WisdomTree funds, you will probably find a word of caution because they are heavy in financials and, with the curve flattening/inverting (depending on when the article was written), the funds could have problems.

That's right, yield curve. It all reverts to the yield curve. Fundamentally weighted funds tilt to value. Value lags growth with a flat or inverted curve, because debt offerings (the manner in which more mature value companies access capital) are not as easy to price, and value companies can't issue stock as easily as growth companies because it is too dilutive.

Growth also beat value in the late 1990's, and the curve was flat on the way to an inversion back then. This is just how capital tends to flow, and during periods of steep curves value leads. This is how the market works, or has worked anyway.

Subprime is a little too narrow an explanation. The inverted curve created a poor environment for financial stocks which hurt the fundamental products, especially where WisdomTree was concerned.

In terms of looking forward, blaming subprime isn't quite right because it will never happen again. Now is the subprime event. There won't be another (here I am not saying how long it will take subprime to work itself out and be over), but there will be future yield curve inversions. And when it happens again, growth will beat value, and fundamentally weighted products will very likely lag cap weighted.

This fact should not make fundamentally weighted any more, or less, attractive. If value continues to outperform growth, as it usually does over long periods of time, then it makes sense to think fundamentally weighted funds, that are properly constructed, should outperform cap weighted indexes, future lags when the curve inverts notwithstanding.

Further reading:
Broad Fundamental Index ETFs
Fundamental Sector Index ETFs