Fundamental Indexation

Abstract:     
The insights from the celebrated Capital Asset Pricing Model have led many to champion capitalization-weighted equity market portfolios as mean-variance optimal. Armed with these insights, investment managers and consultants have created a trillion dollar industry, based on investing in passive capitalization-weighted indexes, such as the S&P 500 and other indexes constructed by Russell, MSCI, The Financial Times, Wilshire, Forbes and Fortune to name a few. Trillions more in actively managed equity portfolios are benchmarked against these same capitalization-weighted indexes. But, the CAPM literature already rejects the mean-variance efficiency of capitalization-weighted equity market indexes. This suggests that it should be possible to construct stock market indexes that are more mean-variance efficient than those based on market capitalization.

In this paper, we examine a series of equity market indexes weighted by fundamental metrics of size, rather than market capitalization. We find that these indexes deliver consistent and significant benefits relative to standard capitalization-weighted market indexes. These indexes exhibit similar beta, liquidity and capacity compared to capitalization-weighted equity market indexes and have very low turnover. They show annual returns that are on average 213 basis points higher than equivalent capitalization-weighted indexes over the 42 years of the study. They contain most of the same stocks found in the traditional equity market indexes, but the weights of the stocks in these new indexes differ materially from their weights in capitalization-weighted indexes. Selection of companies and their weights in the indexes are based on simple measures of firm size such as book value, income, gross dividends, revenues, sales, and total company employment.

While price inefficiency could lead to the observed alpha, as capitalization weighting assuredly overweights the overvalued stocks and underweights undervalued stocks, the superior performance may also be attributable to superior mean-variance portfolio construction or to hidden risk factors (in an APT or Fama-French framework), none of which violates the assumption of price efficiency. Regardless of the exact reason, these Fundamental Indexation indexes appear to provide long-term performance superior to that of comparable capitalization-weighted equity indexes. We offer them not as substitutes for capitalization-weighted indexes, but as simple alternatives, that may offer superior return and risk characteristics.

Keywords: Indexation, Fundamental Indexing, Non-cap based indexing, Mean-Variance Efficiency, Portfolio Construction, Value Premium, Return Predicability

Working Paper Series