Indexed or passive investing has grown in popularity over the last few decades, in part the consequence of occasionally disappointing results from active management, but equally due to the lower governance requirement and lower fees offered by passive management. Estimates suggest that approximately 20% of equity assets are passively managed globally. Traditionally, indices have been constructed using a “market capitalization” approach, whereby individual stocks are weighted by their market cap (=stock price x number of shares outstanding). As such, it is not surprising that the majority of passive equity assets are managed using a “market cap” approach.
More recently, a new approach to indexing has emerged and has been challenging the dominance of market cap as the only way to construct a passive portfolio. Often referred to as fundamental indexing, this approach weights stocks by metrics that reflect their economic size (for example, sales or earnings). Fundamental indexing was founded on the belief that markets are not perfectly efficient and seeks to avoid the “price bias” in market cap portfolios whereby stocks with a high valuations are given a large weighting – and vice versa.
Despite the intellectual appeal, fundamental indices have not been widely adopted by investors, including plan sponsors. This article explores the characteristics of fundamental indices and the considerations that plan sponsors should take into account prior to adopting them.
Performance history and characteristics
Back-testing of fundamental portfolios has shown impressive returns relative to market cap indices, with live performance available for approximately five years. The absolute risk of a fundamental portfolio tends to be slightly less than that of a market cap portfolio, and tracking error is typically in the 3% to 5% range.
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Fundamental indices tend to under-perform market cap indices during strong market rallies and “bubbles”, sometimes to a considerable degree. As can be seen in the chart below, using the S&P 500 as our example, fundamental indexation has under-performed a market cap approach when the market showed strong trending behaviour (including “bubbles”), or was focused on certain themes.
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Users of these indices should have a long-term approach to the investment, particularly if tracking error relative to a market cap portfolio is important (as opposed to absolute risk).
Broadening out our analysis to also include global equities, we see that fundamental indexation has tended to out-perform when returns have been low and under-perform when markets are strongly rising. This feature has the potential to provide a diversification benefit relative to market cap in down markets, although there is no guarantee of this.
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