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The Arithmetic of Fundamental Indexing Authors: Frederick E. Dopfel Source: Journal of Investing, vol. 17, n°2 Date: Summer 2008 |
The author first recalls the important difference between active and passive management, i.e., that if an active fund outperforms, there is necessarily another fund that underperforms, while investors in passive cap-weighted indices accept average investment returns, rather than take the risk of earning inferior returns. The recently introduced fundamental indices look more like active strategies than passive indices, since they seek to outperform cap-weighted indices. In this article, the author proposes to identify the specific conditions in which one would do well to invest in fundamental indices.
Cap-weighted indices have been adopted by a vast majority of investors because these indices are simple to understand, are rebalanced automatically, have lower costs, and represent the performance of the average investor. At the same time, the belief that markets are not perfectly efficient has encouraged investors to seek active strategies that outperform cap-weighted indices. Fundamental indexation is part of this quest. But this quest for outperfomance may be difficult. To support his argument, the author cites Sharpe’s (1991) words, that active management is always a zero-sum game: the average of the active investment must be equal to the average of the entire market. The performance of individual active investments may be above or below average, but the arithmetic sum of these increments is zero. Dopfel notes that this principle holds in all markets, regardless of inefficiency or noise in market prices.
In view of this principle, the author asserts that fundamental indices can outperform or underperform cap-weighted indices, depending on the period, but that their performance will be less certain than that of cap-weighted indices. Consequently, there should be an additional expected return to compensate investors for additional risk. To understand fundamental index performance, the author suggests decrypting its construction methodology rather than considering the theory of noisy markets and mispricing effects. The weighting of fundamental indices, it turns out, is based entirely on four classic value factors (thus making fundamental indexation simply a form of value investing), as can be verified by a return-based style analysis (Sharpe 1992). This analysis reveals significant value biases that account for the major return contribution to the indices. It is for this reason that fundamental indices outperform cap-weighted indices in periods during which value outperforms growth strategies.
Dopfel suggests defining the settings in which it can be advantageous to invest in fundamental indices, or more generally, in market-value-indifferent indices. In fact, three conditions should be met. The first is that the strategy be based on sound forward-looking principles. The second is that the rationale for the fundamental strategy be effectively implemented. The third has to do with the cost of the strategy, which should be compensated for by additional expected return. For this latter condition, the author recommends evaluating the potential interest of the strategy with its expected information ratio. The author concludes that if these three conditions are not met, investors should choose cap-weighting and efficient investment mimicking average investor performance, with minimal costs and without assuming the possible existence of above-average skill.
Dopfel argues that fundamental indexation would more properly be called value-oriented active investing, which would put an end to the debate between those advocating fundamental indexation and their detractors.
References
Sharpe, William F., “The Arithmetic of Active Management”, Financial Analysts Journal, vol. 47, January/February 1991.
Sharpe, William F., “Asset Allocation: Management Style and Performance Measurement”, Journal of Portfolio Management, Winter 1992.
