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Debating 'Fundamental Weighting' and Indexing

Assembling portfolios of companies ordered simply by the price a market has assigned them is perfectly fine as A method of assembling an index. But to give this method some sort of primacy seems self-evidently irrational.

If you needed to buy 10 hens once a year, you probably you would do okay by simply going to the market, finding the 10-chicken-pen that the market has assigned the greatest value to, and buying those chickens, year in and year out.

But what if you went back to the market one year and, in addition to just the market price, each pen had another number which was the egg yield: the number of eggs laid during the past year divided by the market price? And another number: new chickens hatched divided by the market price?

In the former case the market has looked at all the pens and assigned each a value. This value is based part on past performance and part of future expectations. But you have no information how much of the value is based on actual performance and how much is based on expectations. In this case you have information about the entity, the chicken pen, but this information is secondary, derivative. The price is reflective of the value of the chicken pen, but it is not the value.

In the latter case you still have this secondary, derivative information of market price assigned. But now you have additional information, and this data is primary to the object itself: egg production and fertility numbers.

Instead of calling it a market cap index it really should be called a "high hopes and expectations" index because, though analysis on the hard fundamental data is part of the price assignation, no effort is made to order market-cap weighted indexes on anything other than that: market value. In this sense these types of indexes are ordered, by varying degrees, on the hopes and prayers of market participants.

Ordering hens or stocks in accordance with more objective performance measures does not totally expunge the index of hopes and prayers. You are basing this ordering on past performance in the hopes that past is predictive, which often it is not. But there is no doubt less hoping and praying, and therefore more science, inside a fundamental index than inside a cap-weight index.

There is indeed the problem that ordering indexes on fundamentals introduces overweighting to certain sectors, and these, and other problems, need to be addressed. But as we saw during the last great bubble, there were huge overweightings that happened inside of market-cap weighted indexes as well. What got overweighted was euphoria, irrational exuberance, and stocks getting priced higher and higher, growing more and more "valuable" simply because they kept going up and up, until many of the high priced chickens got their heads chopped off, ran around a little more, ran off a cliff, or simply keeled over, and died.

Buying a market-cap weighted index isn't as uncertain as buying 2 chickens in a bush, but more uncertain than buying a fundamentally-weighted index, which is closer to buying 1 chicken in hand.

We are always to some degree, even inside an index, picking stocks. There is a lot of slicing-and-dicing silliness going on around indexing, and more to come, but ordering and packaging securities in accordance with fundamentals such as earnings, sales, book value, or dividends is a valid way to construct an index. To do so is no less valid than ordering an index in lockstep to the values assigned to securities by a herd. Market herds can be smart, and most of the time correct, but sometimes they do stupid things. An index doesn't have to be constructed to slavishly follow them everywhere, even over a cliff, to be correct.

Debating 'Fundamental Weighting' and Indexing

Irony: if or when everyone in the world adopts the efficient market religion and simply buys an index fund, the market will be maximally inefficient because there will be nobody left doing the head scratching analysis that supposedly renders the market efficient in the first place. So there is a symbiotic relationship between active and passive investors. Both need the other to make their version of extracting returns from the market possible. More passive investors means less stock analysis means more market inefficiency. More active investors means information is more fully, more quickly, priced, means more market efficiency. Stock pickers need indexers. Indexers need stock pickers. Both make the other's world go round.