Fundamental Indexation Research Articles

The impact of analyst forecast errors on fundamental indexation: the Australian evidence

Evidence from many developed markets suggests that fundamental indices outperform capitalisation-weighted indices. Existing studies suspect a story of market mispricing, yet a mechanism has not been identified. Using Australian data, we study the relation between analyst forecast errors and the performance of various fundamental indices. We find that fundamental indices contain a relatively higher exposure to stocks with low analyst long-term growth forecasts. Valuations for these stocks are ex ante overly pessimistic and drive the statistical significance of alphas produced by fundamental indexation. We show how hedging against analyst forecast errors can generate additional alpha for investors using fundamental indexation.

Does the fundamental indexation portfolio perform better? An Indian investigation

PurposeThis study aims to compare the fundamental indexation (FI) portfolio vis-à-vis the cap-weighted index (CWI). It also explored the return-generating attributes of the FI portfolios.Design/methodology/approachThis study extracted relevant data from the Centre for Monitoring Indian Economy’s Prowess database from March 1996 to March 2017 from a sample of National Stock Exchange (NSE) 500 companies. The FI portfolios were constructed with First_50 and Next_50 stocks using the latest and five years of trailing average aggregations. Further, the regression technique was used to identify the return-generating attributes of FI portfolios.FindingsIt was found that the FI portfolios based on First_50 and Next_50 stocks outperformed the CWI (i.e. NSE_First_50 and NSE_Next_50) in the Indian capital market, and between the two, the FI portfolios based on Next_50 stocks were superior to the FI portfolios based on First_50 stocks. The cross-sectional superiority of FI portfolios is obvious if they are sorted according to four fundamentals, namely, total income, sales, operating cash flows and profit before depreciation interest tax and amortisation. The return-generating process of FI portfolios is well-explained by market premium followed by value premium and investment premium.Practical implicationsThis study may enable portfolio managers and investors to measure FI portfolios’ superiority in the Indian capital market and identify the return-generating attributes of FI portfolios so that the loadings can be switched amongst different priced factors for higher yield. Further, this study extends the FI literature, providing evidence from one of the world’s fastest-growing economies.Originality/valueTo the best of the knowledge, this is amongst the first few studies to explore the performance of FI portfolios vis-à-vis CWIs in India, and to use Fama and French (2015) asset pricing models to understand the return-generating attributes of FI portfolios. It is also novel in the sense that it considers the FI portfolios for a longer duration, predating 1997 and coinciding with the inception of CWIs, namely, NSE_First_50 (inception: 1995) and NSE_Next_50 (inception: 1996), reducing the apprehensions of data-snooping biases.

Do fundamental portfolios outperform in the MENA equity markets?

PurposeThis study aims to investigate the performance of fundamental weighted portfolios (using sales, cash flows, dividends, book values and a composite of all these variables), an equal weighted portfolio and a smoothed cap-weighted (CW) portfolio in Middle East and North Africa (MENA) markets. The performance of these portfolios is compared with that of a CW portfolio for the period 2005 to 2015.Design/methodology/approachThe portfolios are formed using different concentration levels, different construction schemes and different sub-regions. The performance is assessed using a large set of risk-adjusted performance measures, including more robust measures in the context of multi-factor models, such as the Fama and French (1993) three-factor model, the Fama and French (2015) five-factor model and a seven-factor model.FindingsThe results show that the fundamental portfolios, with the exception of the sales portfolio, underperform the CW portfolio using either the traditional or more robust risk-adjusted performance measures. The underperformance of the fundamental portfolios is found to be robust using different concentration levels, different construction schemes and different sub-regions. The results also show that the equal weighted portfolio outperforms the CW portfolio using traditional risk-adjusted measures. However, after controlling for additional risk factors, this outperformance disappears.Practical implicationsThe failure of fundamental indexation in the emerging markets could help the researchers and the academics to search for the best weighting method that could be used as an alternative to the CW indexation method.Originality/valueThe results of the study add evidence to the debatable propositions on the performance of fundamental portfolios in emerging markets. Furthermore, the findings may help domestic and international investors, practitioners and decision-makers to deepen their knowledge in terms of the best portfolio construction scheme in the MENA region.

Revisiting Fundamental Indexation: A Deep Dive into Revenue

The capital shift to passive investing is among the most important evolutions in investment management in the last four decades. Striking in its magnitude and relative speed of adoption, the significance for asset management, and investors more broadly, is still not well understood. Those switching to passive investing have predominantly turned to indexing, with broad-based market and asset class indices seeing the vast majority of these inflows. Moreover, indexing has been dominated by a simple market-capitalization weighting mechanism. In this study, we bring new evidence to bear on the optimal weighting of indexing strategies for those wanting broad-based exposure to equities in both the U.S. and abroad. In particular, we document three main findings: (1) along with several other methodologies, revenue weighting has outperformed market-capitalization weighting in both absolute returns and return per-unit-risk over the past 40 years in the U.S., (2) revenue weighting provides more stable exposures to industries over this period, and (3) while the international evidence is more mixed, in developed markets and in the largest emerging market economies, revenue weighting appears to dominate market-cap weighting in terms of return and return per-unit-risk over the recent history through present-day. Given the totality of evidence, revenue weighting appears to be a fitting alternative when considering an allocation to broad indexation approaches.

Analysis of Fundamental Indexation as an Efficient Approach to Active Investing

For many years researchers have been arguing on whether active investing is superior to passive investing by giving theoretical and empirical rationale underlying their beliefs. A desire to over-perform passive investing by utilising fundamentally-justified methodology has led to the development of numerous active and semi-active strategies, such as Fundamental indexation established in 2005 by Arnott et. al. In their research, the authors suggested constructing investment portfolios by assigning the weights of each asset concerning the values of its fundamental indicators. This approach has met heavily critique for the lack of theoretical rationale, by not being able to connect the values of selected fundamental indicators to the future performance of the portfolio. In this research, the thesis of passive investing superiority has been challenged by constructing an active investing strategy based on Fundamental Index described by Arnott et al. (2005) - Modified Fundamental Index and testing it on the UK stock exchange companies. The resulted portfolio showed superior performance compared to the cap-weighted index while also having lower risks and higher diversification. Also, I suggested some ideas for further research concerning MFI.

Fundamental Indexation in Brazil: a competitive strategy?

Purpose – This article analyzes fundamental indexation in Brazil relative to the IBrX 100 and selected stock funds in the period between June 2003 and May 2015. This strategy relies on weights based on fundamental indicators and not on market prices. Design/methodology/approach – Fundamental indices built with the IBrX 100 stocks were weighted according to fundamental indicators. The fundamental weighting method sets the weight of each stock as proportional to a previously determined fundament value. This article also considers an ordinal weighting. Findings – The results indicate that fundamental indices do not display positive and statistically significant returns and alphas after adjusting a five risk factor model and transaction costs. The ordinal weighting suggests that fundamental indicator outliers do not drive results. The evidence also suggests that fundamental indices might perform better in bear markets. Originality/value – In general, fundamental indices behave like value stocks and do not present abnormal returns. This is consistent with the absence of fundamental index products in the Brazilian market.

A comprehensive study on smart beta strategies in the A-share market

ABSTRACTIn this article, we explore how smart beta strategies are applied in the Chinese A-share market. Specifically, we empirically examine several popular smart beta strategies, including mean-variance optimization, minimum-variance portfolio, equal weighting, risk parity strategy, and fundamental indexation, and we do so using the Shanghai Stock Exchange (SSE) 50 index and SSE sector indices as our comparison benchmarks. We find that all smart beta strategies outperform these benchmarks from year 2006 to year 2015, and that all smart beta strategies outperform the SSE 50 index by an average of 2.57% per year. In turn, these strategies improve the Sharpe Ratio by 46.2% on average.

Nothing Lasts Forever (and Everywhere): Fundamental Indexation at the Global Level

Fundamental indexation is commonly employed to form portfolios of stocks, but can we also use it to form portfolios of countries? The authors investigate whether fundamental weighting can be applied to enhance the profits from international diversification. To this end, they form and evaluate fundamental indexation strategies within an up-to-date sample of equity benchmarks covering 71 countries for the years 1995–2017. The fundamentally weighted portfolios indeed outperform capitalization-weighted indexes, but significant benefits are largely limited to emerging and frontier markets and almost disappear from the post-2007 period. The abnormal returns result from additional exposure to country-level value and size effects, which have delivered disappointing performance in the past decade.

Fundamental indexation: An application to the Nordic wholesale electricity market

In commodities futures trading, models are often applied to determine an optimal trading strategy. Traditional trading strategies employed include short (sell) and long (buy) positions, time, and locational spreads. Shorter-term power contracts, however, have relatively low correlations with financial markets because of fundamental supply-demand factors including a high correlation with weather effects. Based on the concept of fundamental indexation pioneered by Arnott et al. we investigate the application of a fundamental portfolio weighting indexation to power markets. We propose three fundamental indices, inverse inflow, inverse production and consumption, related to supply and demand, and which historically exhibit strong correlations with power prices. We benchmark the three indices to an equally weighted portfolio of the Nordic market's weekly futures prices (one to six weeks to delivery) from 1996 to 2006. The results show that the inverse inflow index obtains the highest returns. We conclude that the use of the indices combined with portfolio theory would benefit renewable energy plant operators and energy traders.

Fundamental indexation for developed, emerging, and frontier government bond markets

We examine the risk and return characteristics of fundamental weighting schemes for developed, emerging, and frontier government bond markets and compare these to market-capitalization-weighted indexes. We document positive excess returns for the investment grade sample only when currency risks are not hedged, suggesting that fundamentals might be more important for currency rather than bond returns. For emerging and frontier markets, we find positive excess returns for fundamental weighting schemes, although not always statistically significant. The excess returns from fundamental weighting schemes for government bonds can be explained by standard factors from equity, currency, or bond markets.

Does Fundamental Indexation Really Offer Unique Superior Risk-Return Characteristics?

Over the last decade, the concept of ‘smart beta’ has emerged as one of the most disruptive trends in the financial industry. The pioneering paper ‘Fundamental Indexation’ by Arnott, Hsu and Moore (2005) stimulated an extensive discussion about the benefits and drawbacks of factor-based investment products, but there has been limited scrutiny of how the indices perform – that is, whether they are successful in their core focus. Using annual data for the oldest ‘smart beta’ exchange-traded fund, PowerShares FTSE RAFI US 1000 (RAFI), we compute several widely-accepted measures of risk and analyse the performance of this fund in different time frames. We compare this fund with the two main cap-weighted indices – the S&P 500 and the Russell 1000 – or, more precisely, with their exchange-traded versions – the SPDR S&P 500 ETF Trust and the iShares Russell 1000 ETF. We find that the RAFI outperforms the index-based ETFs by 0.9% and 1.0% respectively in compound annual growth rate terms (2006-2016), but we believe that this is overwhelmingly due to the performance of the index in 2009, when the RAFI outperformed the S&P 500 by 16.0% and the Russell 1000 by 14.2%. Without this anomaly (i.e. if RAFI earned the same return as Russell 1000 in 2009), the index’s returns are reduced to only outperform S&P 500 and Russell 1000 by 0.17% and 0.04% respectively. We provide evidence that the source of the out-performance in 2009 is not likely to arise from the core nature of the index. We feel that there are two possible reasons for it, the rebalancing of the RAFI and the timing of this rebalancing. These findings then accentuate several risks that we believe the ‘smart beta’ strategies to carry, and show that investors should increase their scrutiny of the sector.

Fundamental Indexation in European Emerging Markets

Fundamental indexations for common stocks refers to weighting portfolio constituents on the basis of fundamental variables. We examine the cost efficiency of this approach in the three largest European emerging markets: Poland, Russia, and Turkey. We form portfolios based net profits, sales, book values, and dividends, and evaluate their performance in the 2002-2015 period. The fundamentally weighted portfolios deliver higher risk-adjusted returns than standard capitalization-weighted portfolios, but the differences are predominantly statistically insignificant. The abnormal performance remains positive after controlling for trading costs. As a result, the study offers a cost-effective portfolio construction method that could be implemented by international investment managers with a focus on emerging markets.

Smart Beta Is Not Monkey Business

Monkey portfolio proponents argue that all smart beta strategies generate positive value and small-cap exposure, which fully explains their outperformance. They also claim that similar results are obtained by any random portfolio strategy, including the inverse of such strategies. We analyze these claims using test portfolios that follow commonly employed methodologies for explicit factor-tilted indexes. Our results directly invalidate the hypothesis that these claims hold for all smart beta strategies. In particular, our results show that, although some strategies such as fundamental equity indexation may perhaps mostly be driven by a value tilt and may generate similar performance to their upside-down counterpart, many smart beta strategies display exposure to additional factors, as well as pronounced differences in factor exposures across different strategies. Moreover, and perhaps reassuringly, the inverse of these strategies generates lower performance. That our findings directly contradict the monkey portfolio claims can be explained by our set of test portfolios. Although the monkey portfolio arguments may hold for the particular smart beta specifications tested by its proponents, they do not hold in general. An important implication of our results is that one should take care to avoid overgeneralizing tests of particular specifications of smart beta. For the explicit factor-tilted strategies tested here, our results imply that a careful assessment of investment philosophy and index design is indeed relevant as such strategies do not behave like monkey portfolios.

Is Fundamental Indexation able to time the market? Evidence from the Dow Jones Industrial Average and the Russell 1000

Fundamental Indexation weights stock according to a firm's economic size, not stock price or market capitalization. This means that at least in theory, unlike traditional market capitalization weighted indexes, it prevents overinvestment in overpriced stock and vice versa. It should therefore effectively time the market by avoiding incorrect investment in cyclically mispriced stock. We ascertain if Fundamental Indexation outperforms traditional indexing and whether any outperformance can be attributed to market timing. Using almost fifty years of Dow Jones Industrial Average index and Russell 1000 index returns, we find some evidence of limited market timing but no evidence of overall positive abnormal performance.

Fundamental versus Traditional Indexation for International Mutual Funds: Evaluating DFA, WisdomTree, and RAFI PowerShares

Do fundamental index funds beat traditional ones? The major companies that offer the new fundamentally indexed international mutual funds are Dimensional Fund Advisors (DFA), Research Affiliates, and WisdomTree. A major provider of traditional international index funds is DFA. We compare various fundamental international index fund portfolios from these providers with individualized benchmark portfolios composed of DFA traditional international funds. For each fund family, we provide 16 measures of how much an aggregate of its fundamental indexes out-returned its corresponding DFA traditional benchmark portfolio through June 2014. Taking averages, (1) the Research Affiliates PowerShare portfolio out-returned its corresponding DFA traditional benchmark portfolio by 1.08%/year, (2) the average DFA fundamental portfolio under-returned by 0.30%/year, and (3) the WisdomTree portfolio under-returned by 0.74%/year. One cheer for fundamental international indexation and two for traditional indexation.

Is Fundamental Indexation Able to Time the Market? Evidence from the Dow Jones Industrial Average

Fundamental Indexation weights stock according to a firm’s economic size, not stock price or market capitalization. This means that, at least in theory, unlike traditional market capitalization weighted indexes, it prevents overinvestment in overpriced stock and vice-versa. It should effectively time the market by avoiding incorrect investment in cyclically mispriced stock. We ascertain if Fundamental Indexation outperforms traditional indexing and whether any outperformance can be attributed to market timing. Using almost fifty years of Dow Jones Industrial Average Index and Russell 1000 Index returns, we find some evidence of limited market timing but no evidence of overall positive abnormal performance.

Risk weighted alpha index – analysis of the ASX50 index

Major stock indexes are developed on the market capitalization or price weighted indexation method. The Australian Stock Exchange 50 (ASX50) index is a market capitalization index of the top 50 Australian stocks. Fundamental indexation, equal weighted index and risk weighted index methods have recently been developed as an alternative to the market cap and price indexes. However, empirical studies do not conclusively prove if these alternate methods are more efficient to the existing market cap or price weighted methods. Also, the fundamental index method provides a higher alpha, while the risk weighted index methods focus on risk reduction through diversification. There is a gap to develop another passive indexation method in order to provide the investor a higher return (alpha) and lower volatility. This paper re-weights the ASX50 index using the risk weighted alpha method and provides higher weight to stocks that have increasing returns and lower volatility. The empirical study for ASX50 index from 2002-2012 is undertaken and results show that the risk weighted alpha method provides higher return and has lower systematic risk than the ASX50 index.

Price Dependencies and Investors’ Choice

Under the efficient market hypothesis, where many investors resort to “buy and hold” strategies with maximum diversifications, “capitalization-weighted indexation” may offer investors the best risk-return combination. But the existence of non-linear dependences shows that prices of securities may be subject to temporary shocks that obscure their true value. In this case, “fundamental indexation” may achieve returns superior to the capitalization-weighted indexation.

An Evaluation of Alternative Equity Indices - Part 2: Fundamental Weighting Schemes

In this paper we explore an alternative approach for determining constituent weights for equity indices. This approach makes use of alternative definitions of company size, and is referred to as Fundamental Indexation (Arnott et al (2005)). Based upon a data set that comprises the largest 1,000 US stocks for each year in our sample, our results show that between 1968 and 2011 the fundamental index alternatives that we consider have out-performed a comparable index constructed on the basis of the market capitalisation of the index constituents in risk-adjusted terms. Our Monte Carlo experiments show that this superior risk-adjusted performance cannot be attributed easily to luck. We also find that although the superior performance is achieved with higher constituent turnover than required using the Market-cap approach to index construction, the turnover is lower, and in some cases much lower, than required by some of the heuristic and optimised index construction techniques that we explored in our last paper. Finally, we find that although the application of a simple market-timing rule does not enhance the returns on these fundamentally-weighted indices very significantly, it does reduce the volatility of their returns and their maximum drawdown quite considerably.

Does fundamental indexation lead to better risk‐adjusted returns? New evidence from Australian Securities Exchange

AbstractWe investigate the claims of superiority of fundamental indexation strategy over capitalisation‐weighted indexation using data for Australian Securities Exchange listed stocks. While our results are in line with the outperformance observed in other geographical markets, we find that the excess returns from fundamental indexation in Australian market are much higher. On a rolling 5‐year basis, the fundamental index always outperforms the capitalisation‐weighted index. Our results suggest that superior performance of fundamental indexation could not be entirely attributed to value, size or momentum effects. The outperformance persists even after adjusting for slightly higher transaction costs related to turnover.