Fundamentally Weighted Index

What is a Fundamentally Weighted Index?

Fundamentally weighted indices are an alternative form of equity index construction in which the weightings of individual holdings are determined by a set of fundamental criteria, unlike traditional indices that reflect only the companies’ size as measured by its market capitalization. The approach aims to prioritize the company’s actual financial strength rather than its market value which can be inflated or underappreciated by investors. Examples of fundamental metrics that are used to design such an index include revenue and/or earnings growth, dividend yield, book value, etc.

How Fundamentally Weighted Indexes Work?

As the size of individual constituents in traditional market-cap weighted indices is driven by investor sentiment, there is a danger that such an index would provide higher exposure to the expensive areas of the market. Fundamentally weighted indices attempt to break the link between a stock’s share price and its size in the portfolio by using a mix of financial metrics that are typically employed by bottom-up stock pickers (i.e. investors that make decisions based on the company’s fundamentals). However, that doesn’t mean that size is completely isolated from determining position weights since the largest companies would normally exhibit the biggest earnings or dividends and therefore receive the bigger weights in the index.

In reality, since fundamental indices use the absolute level metrics to assign companies weightings, for example total revenues rather than a price-adjusted metric, they also tend to exhibit large-cap bias (without linking share price). Using total revenues as an indicator, the largest companies generally have the highest revenues (this is applicable to the other metrics mentioned above – earnings and dividends) and therefore receive the largest weights in the index. The approach is often viewed as a “contrarian” because, at its rebalance, it trims the winners (i.e. stocks which price have increased relative to a specific metric) and adds more weight to those companies that underperformed the market relative to the same fundamental metric.

Example of a Fundamentally Weighted Index: FTSE RAFI

The FTSE RAFI is an innovative suite of fundamental indices developed by one of the market leaders in the indexing space – FTSE Russell, in partnership with a company called Research Affiliates that offers smart beta and asset allocation solutions. The first FTSE RAFI index series were launched in 2005 and they were further complemented by a second suite called the FTSE RAFI QSR in 2012.

The approach uses a composite of four fundamental measures – sales, cash flow, dividends and book value, but since this could result in higher constituents’ turnover, variability is reduced by using five-year averages for this first three measures (excluding book value for which the most recently reported value is used). A scoring system which uses averages for the individual companies is used to rank them in descending order and allocate weightings to each constituent.

The below table refers to the FTSE RAFI US 1000 Index (comprised of the largest 1000 US companies ranked by fundamentals in the FTSE Global Equity Index Series) is a simulation of how each one of the fundamental factors, taken individually, has performed relative capitalization weighting and a RAFI four-factor composite.

The above data reveals that the four single factors and the RAFI composite outperformed market cap weighting using the same level of risk (as measured by volatility). In addition, averaging the four factors instead of any individual factor brings the benefit of reducing biases.

Benefits of Fundamentally Weighted Index

Although the approach is more complex compared to the market cap weighted indices, it bears a number of benefits such as:

• Weightings in fundamental indices are determined in-line with the company’s financial strength instead of share price. Over a long-term, this could turn into higher potential returns.
• As market cap indices are influenced by investor sentiment, they could be more volatile compared to fundamentally weighted indices as they are based on metrics less prone to rapid changes in stock price.
• The approach also leads to higher exposure to companies that are closer to their fair value, hence investors avoid overpaying for a stock.
• Fundamentally weighted indices could also provide a more diverse sector exposure by avoiding overcrowded market segments.
• Lower concentration – over time, the approach also provides more balanced weightings representation and avoid overconcentration. For example, the below table shows that the top 10 constituents of the FTSE RAFI US 1000 make up c.17% of the total index, while the top 10 holdings in the FTSE USA All Cap Index represent c.30% of the entire index. In theory, this should also lead to a smoother investor journey as total returns won’t be that reliant to the performance of the constituents concentrated at the top.

Criticisms of Fundamentally Weighted Index

The primary concern regarding fundamentally weighted indices is that they simply represent a value strategy that overweighs companies trading at lower multiples. As a result, following a rebalancing, exposure to stocks which price increased relative to a given fundamental metric is trimmed and the weightings of those that lagged is increased. Although companies with higher allocation are expected to exhibit a value tilt, the approach does not explicitly target value businesses (i.e. companies that are underappreciated by the market) and its exposure to value may be less consistent compared to market capitalization weighted value indices.

The below chart shows the fundamental indices exposure to value by comparing the weighted average price-to-book ratio of the companies in a fundamental index (the FTSE RAFI US 1000) to the same measure for stocks in a comparable capitalization-weighted index. The shaded green area represents the percentage valuation discount relative to the market cap index equivalent.

Conclusion

To sum up, fundamentally weighted indices can be useful for investors who seek differentiated exposure, where the weight of index constituents is independent of their price and market capitalization respectively. This also makes fundamental indices less susceptible to concentration compared to market cap weighted indices.

Additional Resources

Portfolio Performance