Fundamentally Based Indexes - Rationale of Weighting By Fundamentals Versus Other Methods of Index Weighting

Rationale of Weighting By Fundamentals Versus Other Methods of Index Weighting

The traditional method of capitalization-weighting indices might by definition imply overweighting overvalued stocks and underweighting undervalued stocks, assuming a price inefficiency. Since investors cannot observe the true fair value of a company, they cannot remove inefficiency altogether but can arguably remove the systematic inefficiency that is arguably inherent in capitalization-weighted indices. Equal-weighting is one method to remove this claimed inefficiency but suffers from high turnover, high volatility, and the requirement to invest potentially large sums in illiquid stocks.

Weighting by fundamental factors avoids the pitfalls of equal weighting while still removing the claimed systematic inefficiency of capitalization weighting. It weights industries by fundamental factors (also called "Main Street" factors ) such as sales, book value, dividends, earnings, or employees. If a stock’s price gets either too high or too low relative to its fair value, weighting by fundamentals will not reflect this bias as far as there is not perfect correlation between stock prices and economic fundamentals. However, the correlation is quite close since the economic fundamentals used are commonly driving the value of a stock. If we assume no correlation in line with Robert Arnott, this arguably prevents fundamentally based indices from participating in bubbles and crashes and thus reduces its volatility while delivering a higher return. However, the dismal performance of fundamental indices in 2008 when companies such as banks with large fundamentals crashed has shown that it may not prevent it from participating in stock market crashes. When fundamentals change rapidly so may the stock price.