Table Of Contents
Fundamental Indexation Meaning
Fundamental Indexation (FI) refers to a novel investment strategy whereby the assets or securities are weighed or valued by economic factors instead of a firm's market capitalization. The various publicly recorded metrics considered under this approach include the company's size, earnings, book value, dividends, buybacks, sales, and cash flows.
Smart beta investing or fundamental indexing has often been considered a strategic approach in portfolio construction to outperform the market since it emphasizes diversifying the funds across assets based on a company's realistic performance, as evidenced by its economic fundamentals. Thus, it capitalizes on trading on market efficiencies instead of stocks prices.
Table of Contents
- Fundamental Indexation (FI) is a contrarian investing strategy that weights the stocks on economic factors like revenue, dividends, buybacks, cash flows, sales, and book value, and not on the market capitalization for portfolio construction.
- It offers an accurate picture of a company's intrinsic value, which is not influenced by market price movements or investor sentiments.
- In some instances, where market capitalization numbers result in stock overvaluation, the smart beta investing strategy helps outperform the market to generate significant returns.
- While the FI strategy is expected to deliver better returns than traditional investing methods, the cost of rebalancing such portfolios may be high.
Fundamental Indexation Explained
Fundamental Indexation, also called fundamental indexing or smart beta investing, is a contrarian investment approach of weighting the assets according to their economic factors, including the company's book value, dividends and buyouts, earnings, cash flow, sales, and other publicly disclosed financial information. Thus, it focuses on the firm's intrinsic value and not the market value for portfolio creation.
Such an index is believed to outperform the market, capitalizing on market inefficiencies since it is based on critical financial metrics rather than market sentiments or the demand for a particular stock. This is because market prices do not necessarily reflect the actual value of an asset or stock.
The smart beta investing strategy serves as a transparent measure of a company’s worth when investing in it based on its actual economic size. This idea gained traction in the early 2000s when several experts propagated it. When the worldwide economic crisis hit after the dot-com bubble burst in 2000, this portfolio construction strategy was explored even further.
In the 1990s, the stock prices of tech companies increased considerably, leading to an internet boom. At that time, stock prices were weighted by market capitalization driven by the sentiments of optimistic investors. However, the unrealistic boom could not survive for long, and the bubble burst, resulting in a global economic crisis. The first research affiliates' fundamental indexation was introduced in 2005 to base the index weights on company size and not market capitalization.
Studies were also conducted to check the relevance of FI in the context of the Global Financial Crisis (2007-2008) and the European Sovereign Debt Crisis (2009-2010). While Eugene Fama and Kenneth French were the initiators of this concept, Robert Arnott, Philip Moore, and Jason Hsu further added the relevant economic fundamentals for indexation.
Examples
The fundamental indexation method is a widely used modern and contrarian investment strategy to design portfolios with economic factor-based stock weighting. Some examples are discussed below.
Example #1
An October 2012 article highlights that the majority of global bond portfolios utilized issuance-weighted indexes as benchmarks, with a specific focus on developed markets like the US, Europe, and Japan. Fidelity Investments introduced the actively managed Global Bond Fund and International Bond Fund in May 2012, both benchmarked to Gross Domestic Product-weighted (GDP-weighted) indexes, collectively managing $100 million in assets.
Similarly, Pimco's Global Advantage Strategy Bond Institutional, initiated in February 2009, oversaw $5.2 billion in assets. Standish unveiled the World GDP Index in May 2012, evaluating ten countries and country blocs based on nominal GDP, resulting in Japan's weighting standing at 10.8% compared to 20.7% in the Barclays Global Aggregate Bond Index.
The US maintained the highest component at 29.4%, down from 37.2%, while emerging-market exposure rose to 20.9% from 4.8% in the Global Aggregate Index. From January 2009 to August 2012, the World GDP Index's volatility was 6.94% compared to 6.13% for the Global Aggregate, with an annualized return of 7.23% versus 5.92%. However, the robust emerging-market economies posed challenges in the form of extreme volatility and illiquidity.
Moreover, China and India were absent from standard GDP-weighted indexes due to underdeveloped debt markets, and GDP was not a reliable metric for assessing corporate bonds. Despite institutional adoption of GDP-based approaches, such as the Government Pension Fund of Norway, widespread investor acceptance remained elusive. Fidelity and Standish were yet to secure institutional commitments at the time.
Example #2
The investing approach of the Russel RAFI Fundamental Index strategy together accounts for a company's dividends and buybacks, retained operating cash flows, and adjusted sales figures for the last five years to determine the intrinsic weight of its stocks. Moreover, such data is rebalanced quarterly to ensure real-time valuation and change in portfolio management.
This enables investors, analysts, and portfolio managers to align the portfolio construction strategy with economic fundamentals.
Pros And Cons
Fundamental indexation was developed to overcome the pitfalls of the traditional indexing methodology that often resulted in stock overvaluation. Given below are its various advantages and limitations.
Pros
- Outperforms Market Returns: When the indexes are based on a company’s intrinsic value and not market sentiments, such stock selection will likely perform better than the market, capitalizing upon its inefficiencies.
- Lower Risk Involvement: Since stocks are not overvalued due to this method’s non-market capitalization indexing approach, the risk of loss on market correction is expected to be low.
- Based on Publicly Reported Financial Metrics: The weights of stocks are determined on the grounds of realistic economic fundamentals like earnings, cash flows, dividends, buybacks, and sales, signifying a company’s historical performance.
- Mitigates Overvaluation Risk: As it does not rely on market capitalization but uses financial metrics, the possibility of overvaluing stocks due to positive market sentiments is low.
- Liquidity: Like other market capitalization indexation, smart beta investing can offer sufficient liquidity benefits.
- Broad Market Participation and Diversification: It allows diversification across assets weighted on their intrinsic values to mitigate financial risks.
- Free from Behavioral Finance Biases: It is not based on what the market perceives but what the actual statistics or numbers show, thus neutralizing the impact of behavioral finance or investor sentiments on stock valuation.
Cons
- Needs Frequent Rebalancing: The fundamental financial metrics and strategies driving such indexation need to be rebalanced quarterly to provide accurate results. Adjusting the weights of economic fundamentals is crucial.
- High Transaction Cost: Rebalancing of economic fundamentals or factors increases the transaction costs of these stocks.
- Ignores Market Sentiments: It often overlooks market trends or investor sentiments, which may lead to the construction of an inefficient portfolio in some situations, like the market-driven uptrend.
- Similarities with Value Investing: It is often criticized for being a modern version of the value investing strategy, which is based on a similar investment ideology, such as focusing on undervalued stocks.
Frequently Asked Questions (FAQs)
In fundamental indexing, an investment portfolio is devised by weighing a company’s economic or financial metrics, such as dividends, buybacks, earnings, book value, sales, cash flows, and size. Therefore, it values stocks on their intrinsic value and not on their market capitalization. In the traditional indexing methodology, stocks are weighted upon their market capitalization, thus emphasizing their market value as determined by investor sentiments.
Considering the Dow Jones Industrial Average (DJIA), the FI, although efficient in timing a single period of economic crisis, failed to perform the same way in a global financial crisis scenario. However, its performance efficiency relies upon the weighting of size and French-book-to-market factors. The equal-weighted indexing, categorized as the non-market capitalization indexation method, is considered more valuable than the FI.
Critics often raise questions on the efficiency of fundamental indexing since it is an alternatively weighted portfolio strategy whereby small-cap stocks hold high weightage and large-cap stocks are weighted comparatively lower. Therefore, it is considered to be a rebranding of the old value strategy.
Recommended Articles
This has been a guide to Fundamental Indexation and its meaning. Here, we explain the concept in detail along with its examples and pros & cons. You can learn more about it from the following articles –