Fundamental Indexation Research Articles

Buying High Return Low Volatility Technology Stocks

ABSTRACT. Technology stocks provide higher returns but can be associated with high levels of volatility. This occurs are technologies go in and out of fashion, which impacts future profits and stock prices. This paper introduces the concept of Risk Weighted Alpha, which identifies stocks that have outperformed over a long period of time and there is usually a tendency for such stocks to keep growing further. When this trend breaks then this method also advises to keep reducing the weight of these stocks within the portfolio. As an example, the NASDAQ 100 index stocks are analysed to understand how the Risk Weighted Alpha method can be applied. Results show that the Risk Weighted Alpha portfolio delivered three times higher return than the NASDAQ 100 index with the same level of systematic risk.JEL Codes: R53; H54Keywords: indexation; portfolio theory; portfolio construction; stock selection; fundamental indexation and alpha1. IntroductionTechnology companies like Apple, Intel, Google and IBM for example have had exponential growth in stock prices over the years. However, there are numerous companies that have fallen over, especially during the dotcom bubble in 2001-02. So, how do you pick companies that will grow overtime? This paper takes the example of the NASDAQ 100 index to analyze companies that have grown and are expected to keep growing over time compared to those that have not performed. Before we move is discussion further, we need to realize that the NASDAQ 100 is a market capitalization based index. This means that the stocks that form the NASDAQ 100 index are the biggest companies in terms of market capitalization or value that are listed on this index. NASDAQ is primarily an index that lists technology related companies in the United States. Most major indexes like the Dow Jones Industrial Average, SP 2008; 2010) have provided the fundamental indexation method that utilizes five fundamental factors: revenue, sales, cash flow, employment and book value, in order to develop the index weighting of stocks. They argue that the fundamental index is a more efficient indexation method compared to the market capitalization weighted index method. Researchers (Kaplan 2008, Hemminki et al. 2008, Hsu et al. 2006, Blitz et al. 2008, Estrada 2006, Chen et al. 2007, Siegel 2006, Mar et al. 2007, Mar et al. 2009, Blitz et al. 2010 and Basu and Forbes 2013) argue that the evidence is inconclusive if the fundamental index method is actually more efficient than the market capitalization method and if it then this is mainly due to the value and small cap bias in the fundamental index method.An alternative to the market cap and fundamental indexation methods are the equal weighted and risk weighted indexes. Equal weighted indexes as suspected weight each stock with equal weight in the index and are seen to be profit taking indexes because over time they reduce the weight of the stocks that have increased in value and increase the weight of stocks that have decreased in value (Bemartzi and Thaler 2001, Winde liff and Boyle 2004 and DeMiguel et al, 2007). As a result, these indexes are seen to have a high tracking error to market cap based indexes and require frequent index rebalancing. There are a variety of risk weighted index methods that have been developed, which are the minimum variance (MV), equally weighted portfolio, maximum Sharpe ratio (MSR), most diversified portfolio (MDP), equally-weighted risk distribution (ERC) portfolio and semi-variance portfolio (Demey et al. 2010).While, risk weighted methods reduce risk through diversification, they also reduce the overall return. …

Fundamental Indexation For Global Equities: Does Firm Size Matter?

Market capitalization is often used as the weighting methodology for broad market indexes to reflect the performances of large established firms in the market. The market capitalization of a firm is a price-sensitive measure of firm size that self-adjusts to reflect the firms intrinsic value in an efficient capital market. In the presence of investor overreaction, the price-sensitive cap-weighted indexes cease to be mean-variance efficient in that they overweigh overvalued assets and under weigh undervalued assets. Fundamental indexation, proposed by Arnott, Hsu and Moore (2005), argue that fundamental values of a firm such as book value, revenues and earnings are price-insensitive, and hence are not subject to the systematic overshooting of asset prices through noise trading. The aim of this paper is to test whether fundamental-weighted indexes are more mean-variance efficient proxies for large established firms in the global equity market compared to cap-weighted indexes over an extensive 18-year period from 1991 to 2008. Test results show that fundamental-weighted indexes outperform cap-weighted indexes over two sub-periods as well as the overall examination period, during an expansionary market and in turbulent times. A strong negative relationship between the degree of index concentration and the index performance is detected for cap-weighted indexes while no such relationship is detected for the fundamental-weighted indexes. Our results suggest that price-insensitive fundamental-weighted indexes are more mean-variance efficient proxies for the performances of large firms for global equities relative to cap-weighted indexes. By removing the price-element in measuring firm size, the small firm anomaly is not present in fundamental-weighted indexes.

Managing Sovereign Credit Risk in Bond Portfolios

With the recent development of the European debt crisis, traditional index bond management has been severely called into question. We focus here on the risk issues raised by the classical market-capitalization weighting scheme. We propose an approach to properly measure sovereign credit risk in a fixed-income portfolio. For that, we assume that CDS spreads follow a SABR process and we derive a sovereign credit risk measure based on CDS spreads and duration of portfolio bonds. We then consider two alternative weighting methods which are fundamental indexation and risk-based indexation. Fundamental indexation is based on GDP indexation whereas risk-based indexation uses a risk-budgeting approach based on our sovereign credit risk measure. We then compare all these methods in terms of risk, diversification and performance. We show that the risk-budgeting approach is the most appropriate scheme to manage sovereign risk in bond portfolios and gives very appealing results with respect to active management of bond portfolios.

Does Fundamental Indexation Lead to Better Risk Adjusted Returns? New Evidence from Australian Securities Exchange

Fundamental indexing based on accounting valuation has drawn significant interest from academics and practitioners in recent times as an alternative to capitalisation weighted indexing based on market valuation. This paper investigates the claims of superiority of fundamental indexation strategy by using data for Australian Securities Exchange (ASX) listed stocks between 1985 and 2010. Not only do our results strongly support the outperformance claims observed in other geographical markets, we find that the excess returns from fundamental indexation in Australian market are actually much higher. The fundamental indexation strategy does underperform during strong bull markets although this effect diminishes with longer time horizons. Contrary to many previous studies, our results show that superior performance of fundamental indexation could not be attributed to value or size premium. Overall, the findings indicate that fundamental indexation could offer potential outperformance of traditional indexation based on market capitalisation even after adjusting for the former’s slightly higher turnover and transaction costs.

Nonlinear Exposures of Fundamental Index Returns

The Research Affiliates Index (RAFI) methodology is a fundamental weighting strategy which has rapidly built up its popularity and investors can invest in the strategy using Exchange Traded Funds (ETFs). In this article, these investment vehicles are investigated with a consideration of their nonlinear exposure to their benchmark factors. The results provide some evidence for out-performance of the RAFI methodology. Further, portfolios following the strategy may exhibit some spurious market timing characteristics which can be explained as an omitted variable bias in the analysis. The evidence for omitted variables after adjusting for book-to-market anomaly implies that fundamental indexation is not just about value bias. <b>TOPICS:</b>Exchange-traded funds and applications, fundamental equity analysis, performance measurement

Risk-Based Indexation

A capitalization-weighted index is the most common way to gain access to broad equity market performance. These portfolios are generally concentrated in a few stocks and present some lack of diversification. In order to avoid this drawback or to simply diversify market exposure, alternative indexation methods have recently prompted great interest, both from academic researchers and market practitioners. Fundamental indexation computes weights with regard to economic measures, while risk-based indexation focuses on risk and diversification criteria. This paper describes risk-based indexation methodologies, highlights potential practical issues when implemented, and illustrates these issues as it applies to the Euro Stoxx 50 universe.

Mutual Funds: Portfolio Structures, Analysis, Management, and Stewardship

Mutual Funds: Portfolio Structures, Analysis, Management, and Stewardship

Fundamental Indexation: An Australian Investigation

Capitalisation-weighted indexes provide the basis for passive investment strategies designed to capture market performance. However, these cap-weighted indexes are claimed to be sub-optimal because of their tendency to overweight overvalued shares and underweight undervalued shares. U.S. evidence suggests that fundamental indexes, which select, rank and weight stocks according to fundamental measures of size such as book value and revenue, outperform cap-weighted indexes. This study examines fundamental indexation in an Australian context over the period 1995 to 2006 and finds support for the U.S. results. However, we also find that the superiority of fundamental indexation is largely explained by its inherent bias towards value stocks, which raises the question as to whether a more overt value tilt may not provide a superior means for exploiting mispricings in markets.

Fundamental Indexing: An Analysis of the Returns, Risks and Costs of Applying the Strategy

We study the risk-adjusted performance of strategies based on fundamental indexation in Europe. Fundamental indexes are formed on the basis of book value of the assets, gross dividends, revenue, operating income and a composite of these values. Previous research in the US has shown that fundamental indexation provides positive risk-adjusted returns. We analyze whether the fundamental indexing strategy generates a positive alpha after correcting for risk factors and costs of managing the index portfolios. We use the three factor model of Fama and French to correct for risk. We find that fundamental indexation has a higher factor loading on the risk factors based on book-to-market (HML) and size (SMB). We also find that the strategy generates significant alpha after correcting for the three risk factors.

Fundamental indexation: An active value strategy in disguise

In this paper we critically examine the novel concept of fundamental indexation. We argue that fundamental indexation is by definition nothing more than an (elegant) value strategy, because the weights of stocks in a fundamental index and a market capitalization-weighted index only differ as a result of differences in valuation ratios. Moreover, fundamental indices more resemble active investment strategies than classic passive indices, because (i) they appear to be at odds with market equilibrium, (ii) they do not represent a buy-and-hold strategy and (iii) they require several subjective choices. Last but not least, because fundamental indices are primarily designed for simplicity and appeal, they are unlikely to be the most efficient way of benefiting from the value premium. Compared to more sophisticated, multi-factor quantitative strategies, fundamental indexation is likely to be an even more inferior proposition.

Fundamental Indexation: An Active Value Strategy in Disguise

In this paper we critically examine the novel concept of fundamental indexation. We argue that fundamental indexation is by definition nothing more than an (elegant) value strategy, because the weights of stocks in a fundamental index and a market capitalization-weighted index only differ as a result of differences in valuation ratios. Moreover, fundamental indices more resemble active investment strategies than classic passive indices, because (i) they appear to be at odds with market equilibrium, (ii) they do not represent a buy-and-hold strategy and (iii) they require several subjective choices. Last but not least, because fundamental indices are primarily designed for simplicity and appeal, they are unlikely to be the most efficient way of benefiting from the value premium. Compared to more sophisticated, multi-factor quantitative strategies, fundamental indexation is likely to be an even more inferior proposition.

Fundamental Indexation and International Diversification

Just as fundamental indexation is novel and controversial, international diversification is traditional and widely accepted. In this article, the author links both issues and evaluates a fundamental strategy of international diversification. Considering 16 country benchmarks that make up over 93% of world market capitalization and a 32-year (1974–2005) sample period, the results show that a dividend-weighted fundamental index outperforms a cap-weighted index by the substantial margin of 190 bps a year. If, however, investors are willing to abandon cap-weighted portfolios, the results also show that a simple value strategy which weights the same country benchmarks by dividend yield outperforms the dividend-weighted fundamental index by 170 bps a year over the same period. All the strategies evaluated by the authors can be easily implemented with widely available low-cost country index funds and exchange-traded funds. <b>TOPICS:</b>Passive strategies, equity portfolio management, in markets

Why Fundamental Indexation Might—or Might Not—Work

Some proponents of fundamental indexation claim that the strategy is based on a new theory in which market prices of stocks deviate from fair values. A key assumption in this approach is that fundamental weights are unbiased estimators of fair value weights that are statistically independent of market values. This article demonstrates that, except in trivial cases, this assumption is internally inconsistent because the sources of the “errors” are also determinants of market values. The article shows under what conditions fundamental weights are better—or worse—estimators of fair value weights than are market value weights, thereby demonstrating that the new theory is merely a conjecture. A formula is developed for the value bias inherent in fundamental weighting, and two approaches to combining fundamental and market values are discussed.

Fundamental Indexation and International Diversification

As much as fundamental indexation is novel and controversial, international diversification is traditional and widely accepted. This article links both issues and evaluates a fundamental strategy of international diversification. Considering 16 country benchmarks that make up over 93% of the world market capitalization and a 32-year (1974-2005) sample period, the results here show that a dividend-weighted fundamental index outperforms a cap-weighted index by the substantial margin of 1.9% a year. However, if investors are willing to abandon cap-weighted portfolios, the results here also show that a simple value strategy that weights the same country benchmarks by dividend yields outperforms the dividend-weighted fundamental index by 1.7% year over the same period. All the strategies evaluated in this article can be easily implemented with widely-available, low-cost country index funds and ETFs.