A different way to weight the market

Far from being a replacement for the solid foundation of an index based on market capitalization, fundamental index strategies can act as a diversifier by removing some beta or broad market exposure. That reduction is accomplished by measuring specific economic factors for individual companies. Consider what happened during the extreme stock market swings of 2008 and 2009. At the height of the financial crisis in 2008, the market-cap-weighted Russell 1000 Index fell by 37.6%. The fundamental-based PowerShares FTSE RAFI 1000 Index did even worse, falling by 40.1%. But during the rally of 2009, when the Russell 1000 gained 28.4%, the PowerShares counterpart gained 41.5%. Keep in mind that both indexes are made up of the same general universe of stocks. The difference is that in a market-cap-weighted index, the weighting is determined by stock price multiplied by the number of outstanding shares, instead of company-specific factors. One of the primary drivers behind the 13.1-percentage-point difference was the fundamental index's exposure to financial-sector stocks, which had experienced the biggest declines in 2008, and thus became a smaller percentage of the market-cap-weighted index going into 2009. But because the fundamental index considers economic factors such as book value, sales, cash flow and dividends, it maintained enough exposure to the financial sector to participate more fully in the 2009 rally. “The cap-weighted indexes tend to overweight the overvalued stocks and underweight the undervalued stocks,” said John Feyerer, head of product strategy and research at Invesco PowerShares Capital Management LLC. “The excess returns [of the fundamental index] are coming from the structural drag created by the cap-weighted indexes,” he said. “All fundamental indexing does is sever the link between a company's share price and its weight in the index.” PowerShares, which introduced the first fundamental-based-index exchange-traded fund in December 2005, now has 16 products and $3.5 billion under management in the category. The basic fundamental indexing model was popularized nearly a decade ago by Robert Arnott, founder of Research Affiliates LLC, but the strategy is just starting to gain real momentum. Over the past two months, state pension plans for Alaska and Oregon allocated more than $1.1 billion to a fundamental index strategy managed by Russell Investments. “Fundamental indexing is a rules-based method of systematically capturing active beta,” said Ken O'Keefe, managing director of indexes at Russell. “It gives investors a different way to invest in the equity markets.” Nearly two dozen firms offer fundamental-based indexes, and according to Mr. O'Keefe, total assets invested in fundamental-index strategies have doubled over the past year to more than $50 billion. On a back-tested basis going back to 1978, fundamental indexing outperformed traditional market-cap-weighted indexing by between 2 and 4 percentage points annually, he said. Although the strategy wasn't active during the technology bubble of the late 1990s and early 2000s, that period serves as a classic example of how fundamental indexing is distinct from indexes based on company size.

CISCO SYSTEMS

In 1999, when the tech bubble was still building, Cisco Systems Inc. Ticker:(CSCO) represented 1.8% of the market-cap-weighted Russell 1000 Index. But as its share price soared, the market-cap-weighted index pushed Cisco's weighting to 3.4%, effectively overweighting an overvalued stock. By the end of 2001, after the tech bubble had burst, Cisco's weighting was down to 1.2%. Meanwhile, a fundamental-index model applied over the same time period would have measured Cisco as a small but growing tech company and given it a 0.11% weighting in 1999. By the end of 2000, the Cisco weighting would have increased to 0.18% and by the end of 2001, it would have been cut to 0.09%, according to Mr. O'Keefe. “The fundamental index is just saying Cisco shouldn't have been that heavily weighted in the index to begin with,” he said. Questions, observations, stock tips? Email Jeff Benjamin at jbenjamin@investmentnews.com