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More Evidence In Support of a Fundamental Index

 wrote a book review recently on The Fundamental Index: A Better Way to Invest. I had a very favorable impression of the book and the evidence presented by the book. I've been browsing CXOAG quite a bit recently and found an article, based on studies of European stocks, that offers more evidence in favor of a fundamental index versus a cap-weighted index:



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.