Fundamental, Equal-Weighted ETFs Beat S&P 500: Report

Includes: SPY
by: Tom Lydon

Over the past five years, fundamental and equal-weighted index methodologies, along with their related ETFs, have been outperforming the market-cap weighted S&P 500 Index, according to a report.

John West, CFA Director and Product Specialist at Research Affiliates, questions the basic methodology of fundamental indexes and how they rationalize overweighting or underweighting certain sectors. More recently, the fundamental strategies have overweighted financials while underweighting energy, which would seem rather counterintuitive given the current environment.

However, West argues that the fundamental index strategy may not matter so much in the short-term since the the methodology is able to “contra-trade” against market fads, crashes, bubbles and speculation in the long run.

In the last five years, the financials sector was the only sector that lost money and underperformed the S&P 500 Index, whereas the other nine sectors all outperformed broad market. The FTSE RAFI U.S. 1000, a fundamental index, held 24% in financials in 2005 as compared to the S&P 500 at 18%, but the FTSE RAFI outperformed the S&P by 2.3% per year as a direct result of contra-trading – the FTSE RAFI regularly rebalanced to bet on active sectors, which proved to be quite fruitful.

West comments on how the index’s methodology breaks the link between stock price and portfolio weight and creates a portfolio that is half invested in overpriced stocks and half invested in underpriced stocks. Additionally, equal-weighted indexes also engage in a similar pricing methodology to provide a similar automated rebalancing effect -- although the equal-weight indexes hold a smaller weighting in energy stocks due to the dearth in mega-cap oil companies.

Max Chen contributed to this article.