Fundamental Indexation: Rebalancing Assumptions and Performance

Abstract

We show that the performance of a fundamental index with annual rebalancing, as proposed by Arnott, Hsu and Moore (2005), can be highly sensitive to the subjective choice of when to rebalance. For the year 2009, for example, we find that a fundamental index rebalanced every March outperformed the capitalization-weighted index by over 10%, whereas a fundamental index rebalanced every September underperformed. We provide intuitive and statistical evidence in support of the hypothesis that if two fundamental indexes diverge, they do not tend to mean-revert subsequently, i.e. the gap is likely to be permanent. This performance ambiguity is an undesirable feature for an index which is used for benchmarking purposes. We introduce the idea of blending multiple underlying fundamental indexes, each one rebalanced annually, but at different dates, as an example of how to construct a more robust fundamental index without increasing turnover.

Keywords: Indexation, Fundamental Indexing, Alternative Beta, Value Premium, Capitalization Weighting, Non-Cap Based Indexing, Portfolio Construction, Rebalancing

JEL Classification: G11, G12