Scott's Investments'  Instablog

Capitalization-weighted stock indexes arguably incorporate a performance drag by overweighting overvalued stocks and underweighting undervalued stocks. In their February 2009 paper entitled "Fundamental Indexing: An Analysis of the Returns, Risks and Costs of Applying the Strategy", Roel Houwer and Auke Plantinga examine the raw and risk-adjusted returns of hypothetical indexes of European stocks weighted by dividend, book value, revenue and operating income. They take the capitalization-weighted Stoxx 600 Index as a benchmark. Using monthly stock returns and firm fundamental data for the Stoxx 600, along with relevant risk-adjustment data, for the period 1993-2007,they conclude that:

• The average return of each fundamental index is higher than that of the Stoxx 600 Index (see the chart below).
• The fundamental indexes tilt more toward value (high book-to-market ratio) stocks and small-capitalization stocks than does the capitalization-weighted benchmark index, but the fundamental indexes still outperform after adjusting for market,size and book-to-market ratio risk factors.
• Turnovers for the fundamental indexes are generally much higher than that for the capitalization-weighted benchmark index. However, the fundamental indexes still outperform the the capitalization-weighted index after accounting for reasonable trading frictions.