Why Fundamental Indexes Lagged Cap-Weighted in '07

IndexUniverse has an article up that recaps 2007. It notes that fundamental indexing like the RAFI ETF (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

Comments

[Long-Short Guy:]

I wonder also whether market cap weighted funds outperformed simply because large caps started to do better again.

On the issue of overweighting financials, that illustrates a problem with the fundamental funds. Some sectors always look cheap on a fundamental basis at certain points in the cycle, and that's why the market places a lower P/E on them. Examples: semis at the top of the cycle, financials. Fundamentally weighted indexes don't make that adjustment, so they get caught.

2008 Jan 31 11:30 AM

[Long-Short Guy:]

Forgot to say: love your articles, Roger.

2008 Jan 31 11:31 AM

[Roger Nusbaum:]

thanks for the kind word.

your first question...yes in a normal cycle small cap leads at the beginning (it leads for most of the cycle actually) and then gives way to large cap at the end, like 1999 or 2007. This has to do with the willingness to assume more risk earlier in the cycle.

I don't think a fund being overweight financials (or some other sector) is what matters. What I think matters is that if you own a fund that is very overweight a sector then the rest of the portfolio needs to compensate for that overweight.

2008 Jan 31 12:19 PM

[Lisa:]

Isn't this also a problem generally overweighting with dividend paying stocks?

2008 Jan 31 12:35 PM

[Roger Nusbaum:]

yes, depending on how much of an overweight you mean. also, if you read the IU piece you will see that foreign did not have the same result

2008 Jan 31 02:21 PM

[JCopp:]

Roger:
Good article. Would this mean that Fundamental Weighting would not work as good in Emerging markets in your opinion?

John

2008 Feb 01 10:43 AM

[granger:]

I agree. I believe it is to one's peril to ever under estimate the long term power of fundamentals.

2008 Feb 01 11:38 AM

[Roger Nusbaum:]

J Copp, I don't really know. i do know that so far DEM has lagged ADRE (a broad based ETF I use for clients and own personally) so maybe so.

Personally i like the idea of an ETF and a couple of individual stocks for EM exposure. I picked ADRE a long time ago prefering it to EEM. That is has beaten DEM might just be luck?

2008 Feb 01 03:54 PM

[Rhunzzz:]

I can't help but think of John Bogle's comment that, over time, growth and value will have their own turns in the financial wilderness (or in the sun), and therefore costs should be the overriding consideration.

The Powershares FTSE RAFI funds are expensive at >70 basis points. The WisdomTree funds are better priced, but they still can't beat Vanguard's <20 basis points. The idea of fundamental weighting makes a lot of sense to me, but those expense ratios make me hesitate.

2008 Apr 09 04:55 AM