Asset allocation
While the genus of fundamental indexing had its roots in investors’ disappointment in active managers’ ability to out-perform, a much earlier form was witnessed when Japan dominated International indices in the late ‘80s. Many investors moved to GDP weights to set regional equity allocations. For example, the impact of the Japanese bubble can be seen in the market cap weighting at the end of the 1980’s. The U.S. allocation was also partly driven by the tech boom at the end of the ‘90s.
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As you can see in the charts above, sector and country allocations change less over time when using a fundamental indexing approach, making fundamental indices less prone to over or underweighting.
Value bias?
Relative to a market cap portfolio, fundamental portfolios tend to have a value bias, although this varies over time. However, fundamental portfolios include all stocks in a given universe, rather than just the “value half”. The natural question is, is fundamental indexing just another value strategy? To some degree this is true. By avoiding market price in the portfolio weighting mechanism, a fundamental portfolio will have more earnings (or sales or dividends) for each dollar of investment.
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Our analysis shows a value tilt to the portfolio, although this has varied over time. Importantly, the value tilt tends to be lower at the start of a period when value struggles (from the mid 1990’s and 2005) and higher at the start of a period of value out-performance (mid 2000).
Investor usage
Given all these obvious benefits, why haven’t fundamental indices been more broadly adopted? There are a number of reasons, which include:
• Relative newness: As with most things new, many plan sponsors don’t want to be first – either on the leading or bleeding edge. There are two main index families available now (Research Affiliates and Global Wealth Allocation), with a much wider range of equity markets covered. However, many plan sponsors will wait until there is more history available for comparison, as well as a broader array of products.
• Complexity: Unlike market cap indices which are simply the product of shares outstanding times price, fundamental indexation is based on a number of metrics that represent a company’s economic size (sales, profit). This is much more complicated to both monitor and measure, requiring both higher level of general market knowledge and increased governance capability.
• Value bias: Many plan sponsors do not want to have a style bias in their investment portfolio. To the extent they do, many have already employed managers with value approaches which are, again, simpler to identify and monitor.
• Additional cost: Fundamental indexing is more costly to access than traditional market cap indexing approaches. Pooled funds can range in price from 20 to 40 basis points.
• Being different: Similar to the newness point, many plan sponsors do not want to look different than their peers. While this is not a financial argument, and in fact, investment strategy should be aligned with a plan sponsor’s desired outcome, the fact remains that peer comparisons are still made.
Conclusions
It is clear that fundamental indexing provides some attractive features for investors. We see investors accessing fundamental approaches in two main ways – as an active strategy, replacing a traditional active manager; and as part of an indexing strategy that combines both fundamental and market cap indexed approaches. Whether fundamental indexing will be more broadly adopted is up for debate and we won’t know the answer to this for many years. Success will likely depend on an increase in markets covered, products available, reduced fees, and of course, performance success.
Janet Rabovsky is Senior Investment Consultant with Towers Watson.
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