Fundamental Indexing Quiets Its Critics

by: Tom Lydon

When the concept of fundamental indexing was first introduced, traditionalists scoffed. But even the staunchest critics have to be convinced of the strategy’s merits now that fundamentally-weighted ETFs have begun to outperform market-cap-weighting strategies.

The Logic Behind Fundamental Indexing

Rob Arnott, chairman of Research Affiliates and the "Father of Fundamental Indexing," says that market cap has its merits as the most widely-used type of index. Market-cap indexes weight their components according to the size of the company.

“The problem is that you’re going to wind up putting more money into companies whenever they’re more expensive,” Arnott says.

And the issue with that is that although a company may double in price, there’s certainly no guarantee that it will perform better once the price has increased.

Another issue Arnott sees with market-cap weighting is that it tends to load up on safe-havens, lofty growth expectations and popular companies. “Why should we pay a risk premium that should reward us when we’re loading up on trendy growth companies?” he asks.

How Fundamental Indexing Works

Fundamental indexing, on the other hand, weights its components according to the size of their business by looking at a variety of factors, including book of sales, dividends, profits, book value and more.

What that does, Arnott says, is create a value tilt: in other words, giving value companies greater sway than growth.

Each of the factors considered in a fundamental weighting strategy winds up being an economically meaningful anchor to the market’s changing views, Arnott says. “As the market changes its views, you’ll weight according to that and put proceed in what’s feared and loathed.”

The wisdom of that strategy, he says, has been borne out time and again. Fundamentally-weighted indexes have outperformed cap-weighted indexes time and again.

Arnott’s indexes are used in several PowerShares ETFs, including PowerShares FTSE RAFI Emerging Markets Portfolio (NYSEARCA:PXH) and PowerShares FTSE RAFI U.S. 1500 Small-Mid Portfolio (NASDAQ:PRFZ), both of which are two of the top-performing fundamentally-indexed ETFs by RAFI in the last few months. For comparison, the S&P 500 and Dow Jones Industrial Average are essentially flat in the last month.

Silencing the Critics

Arnott says that the idea of fundamental indexing wasn’t instantly embraced by everyone. One of the earliest criticisms was that fundamental indexes are a value tilt, something that Arnott doesn’t argue.

“But it’s a special value tilt that’s a dynamic one that contra-trades against the market’s changing views,” he says. “Critics who say it’s just a value tilt – how do they explain that value underperformed 1.4% while RAFI outperformed 2% a year?”

And that wasn’t just in the United States. In fact, fundamental indexes overseas have done even better.

Fundamental indexing isn’t always outperforming, however. When value starts to underperform, fundamental indexes will see performance suffer, as well.

“But when value is winning, we have a tailwind and we win by more,” he says. “You really have to view it over an economic cycle.”

In 2007 and 2008, for example, fundamental indexing did poorly as the broader market suffered. In 2006 and 2009, it did better, while in 2010, value was neutral, though fundamental indexing outperformed 4%.

“It’s a really simple idea that turns out to be pretty darn powerful.”

Who Uses It?

Arnott doesn’t foresee anyone dumping cap-weighted strategies from their portfolios entirely.

Some of his clients have done away with cap-weighting, but they’re in the minority. “Most people how use fundamental indexing currently use it as a complement to classic cap weighting.”

Arnott says the critics have quieted down, too, though they’ll always be there in one form or another, and he’s just fine with that.

“People who will take the other side of our trades? We’re happy to have them.”