Can You Beat the Index?

Fundamental indexation aims to better normal indices without the drawbacks of active management

Morningstar ETF Analysts 24 May, 2010 | 12:35AM
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Historically, the benchmarks used to judge the success of active managers have been market capitalisation-based indices, for example, the EURO STOXX 50 for European equity managers, or the FTSE 100 for domestic British managers, as these benchmarks best represent 'the market,' or the best passive alternative for investors in that asset class. The impetus for this practice was finance theory from the 1950s and '60s that fell under the umbrella terms of Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM). MPT roughly suggested that broad diversification provided one of the few easy benefits for investors by reducing the risk to the overall portfolio from each individual security. CAPM, in turn, worked from the assumption that all investors in the market are trying to build an optimal diversified portfolio, and found this implies that stock and bond prices are set so the total market portfolio offers the best tradeoff of risk for return.

Both theories suggested that investors should hold broad indices weighted by market capitalisation, which are the dominant form of benchmark and passive investment to this day. While this has worked well, as funds based on market-cap indices have been created as an inexpensive alternative to actively managed funds, some argue that alternative weighting methodologies known collectively as “fundamental indexation” could actually improve the risk-to-return ratio of passive indices.

Fundamental indexation uses factors other than market-capitalisation to weigh securities selected for an index, while still holding nearly every stock or bond in the market for diversification. The theory behind fundamental indexation was first introduced in an academic paper in 1992 by Eugene Fama and Kenneth French titled "The Cross-Section of Expected Stock Returns," which argued that market returns did not really explain all of the returns to underlying stocks over the 1963-1990 time frame. Instead, smaller companies and those with a higher accounting value relative to their market value offered higher returns than the market index with lower volatility. This paper empirically established the power of value investing, but used narrow portfolios that only captured one-third or one-tenth of the market. In 2004, firms like Dimensional Fund Advisors and Research Affiliates capitalised on this research by creating the first fundamental indices and funds using every security in the market to provide maximum diversification along with the higher returns from small-cap and value stocks.

It was actually Research Affiliates who coined the term ‘fundamental indexation’ in a paper of the same name published in 2005. They back-tested their methodology against the S&P 500 from 1962-2004 and found that it created a 2% per annum excess return with little or no extra risk. Similar excess return results were seen with the methodology in a 2007 study of 23 international markets.

Theoretically, if you accept that factors like size and value can explain higher returns in stocks, then only the higher costs involved in building and trading a portfolio influenced by those factors should prevent it from outperforming a market cap-based index. Fundamental indexation attempts to lower those costs so that investors can accrue the higher expected returns.

Is Fundamental Indexation Truly Passive, Or Is It an Active Strategy?
Because managers are attempting to outperform the broad market, many argue that fundamental indexation should be considered active management and not a beta strategy. Others counter that since the indices do not pick stocks but in fact include the same securities that would be in the corresponding market cap-based index, they can still be considered passive. In some ways, the argument boils down to semantics since active or passive is ultimately just a label. The more important question is whether or not investor’s needs are served by this strategy.

Is Fundamental Indexation Right for Your Portfolio?
To answer this, let’s first take a look at the pros and cons of fundamental indexation:

- Unlike market-cap based indices, fundamental indexation avoids overweighting individual securities which are overvalued, like at the top of a bubble, or underweighting undervalued securities at times of panic. This likely explained the outperformance of fundamental indices in 2009.

- The factors used by fundamental indexation can be used to diversify your portfolio. For instance, if you own an ETF tracking the EURO STOXX 50, a fundamental index can be used to balance that large-cap bias in your portfolio towards smaller-cap stocks.

- Offers the capability of beating market returns but with lower costs and greater transparency than traditional active management.

- Just as market cap-based indices can overweight overvalued securities, fundamental indices can overweight so-called ‘value traps’. Witness the poor performance of these funds in 2008 as many large financial stocks exhibited great fundamentals like high cash flows and major accounting values relative to their market prices. However, the market had it right, and the underlying fundamentals for these companies rapidly deteriorated, dragging down major banks and mortgage companies along with the fundamental indices that overweighted them.

- Higher turnover as fundamental indices need to be periodically rebalanced leads to higher costs than market-cap based indices.

There is a kind of symmetry in the benefits and drawbacks of fundamental indices in comparison to market cap-based indices. Basically, at times the small-cap and value bias will lead fundamental indices to underperform their market-cap counterparts, and at other times they will outperform. Since it can be argued that any extra return generated by fundamentally-based indices are due to their small-cap and value tilts, it may be difficult to justify their existence when small-cap and value funds already exist. The diversification benefits do not show up in a lower standard deviation or smaller losses than cap-weighted value indices, though the back-tested returns to fundamental indices have been higher at a virtually equal level of risk. Choosing a fund which tracks a fundamentally-based index as opposed to one of the many small-cap and value funds that already exist may largely come down to their relative costs and fees.

Fundamental Indexation ETF Options

At the moment, the options for fundamental indexation ETFs are limited to the FTSE RAFI (Research Affiliates Fundamental Index) series of indices, which use an equal-weighted combination of four factors to weigh securities: total cash dividends, free cash flow, total sales and book equity value. Only two providers currently license the indices, with Lyxor choosing the swap-based route and Powershares opting to use physical replication. Between the two of them they offer plenty of country and regional options to choose from.

Ultimately, low costs are the main reason that passive indices generally outperform active management. Therefore, fundamental indexation ETFs have the same hurdle of higher fees than ‘pure’ passive indices to overcome before generating excess returns that active strategies have. While the historical results are encouraging, it’s a pretty straightforward task for a statistician to data mine for factors that have led to outperformance in the past. Be aware that there’s no guarantee that future results will be similar before placing one of those ETFs in your portfolio.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure.

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