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The Value of Fundamental Indexation Authors: David Blitz, Laurent Swinkels Source: SSRN Date: July 2008 |
Fundamental indices are indices whose constituents are weighted by fundamental indicators. The possible superiority of these indices to cap-weighted indices has sparked animated debate. In this article, the authors compare the construction and performance of fundamental indices and cap-weighted indices.
Their first observation is that fundamental indices are simply an alternative form of value indices, as a fundamental index, compared to a cap-weighted index, will overweight value stocks and underweight growth stocks. According to Blitz and Swinkels, fundamental indexation is merely a new and more sophisticated way of deriving value indices. As a result, the difference in the returns on fundamental and on conventional indices will be explained by the difference in the returns on value and on growth stocks. Empirical observation has provided evidence for the existence of a value premium, as value stocks have historically outperformed growth stocks over the long term, and it is for this reason that fundamental indices have historically outperformed cap-weighted indices.
These observations are confirmed by an empirical test. The authors have computed the alpha of the RAFI 1000 index using both the CAPM and Fama-French 3-factor model. The 0.26% alpha per month obtained with the CAPM drops to an insignificant value of -0.02% with the Fama-French model, which corrects the result from the value tilt, and the RAFI 1000 appears to be significantly exposed to the value index, with a beta of 0.38. So they conclude that, after adjusting for style exposure, fundamental indexation offers no value-added.
Second, they assert that fundamental indices are more of an active strategy than are passive indices. They argue that, contrary to the cap-weighted portfolio, which is the only portfolio that can be held by all investors in market equilibrium, a fundamental portfolio must be counterbalanced by the existence of another portfolio with different views. In addition, unlike a cap-weighted index, a fundamental index does not represent a passive, buy-and-hold strategy. This index must be rebalanced on a regular basis to take into account changes in stock prices. Furthermore, the construction of fundamental indices requires a certain number of choices that appear to be quite subjective, such as the choice of the fundamental indicator and its definition.
Finally, they conclude that, as fundamental indices are nothing more than a value strategy, they are not the most efficient means of capturing the value premium. These indices, it seems, are designed not to incorporate optimal risk/return characteristics, as measured by the Sharpe ratio, but to be simple. In addition, the performance of the indices is not stable over time, as it is related to market cycles. It is possible to obtain better performing quantitative value strategies by designing strategies that seek optimal risk/return characteristics.
The authors also suggest that fundamental indexation merely takes advantage of the value premium, while multi-factor quantitative investment strategies allow investors to benefit from other anomalies, such as the short-term reversal effect, momentum effects, or the low volatility effect. Over the long term, these multi-factor quantitative investment strategies can generate superior and more stable returns than can fundamental indexation.
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