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

Abstract

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.

Keywords: Fundamental Indexation, Asset Pricing, Portfolio Choice

JEL Classification: G11, G12