« Quesition of the Day - Planning | Main | Exploiting the American Worker »
What is Fundamental Indexing?
By JLP | November 14, 2006
When most people hear the word “index,” they most likely think about the Standard & Poors 500 Index. The S& P 500 Index is a market cap-weighted index. That means that the companies with the biggest market values make up the biggest percentage of the index. For those of you who don’t know, “market value” is computed by taking a company’s outstanding shares of stock and multiplying them by the current stock price. According to Robert Arnott in this interview in Investment Advisor Magazine, the flaw with this type of index is that it becomes overweighted with overvalued companies and underweighted with undervalued companies.
I never really thought about it like that but it makes sense. Arnott is a proponent of fundamental indexing, which uses a company’s fundamentals: sales, profits, book value, and dividends to determine its weighting in an index. According to the article, here’s how it works:
We look at a company’s sales, profits, book value, and dividends. If a company is 4% of the economy by sales, 3% by book value and profits, and 2% by the dividends that it pays, then, we could argue is it 2% or 3% or 4% of the economy or we could just take the average, and say “It’s about 3% of the economy and therefore it will be 3% of our index.” We simply equal-weight the four measures; if a company has never paid a dividend we just weight the other three—we don’t want to saddle a company with zero weight for dividends. It’s a simple process and that’s what makes it doubly amazing that it hadn’t been explored decades ago.
This sounds a lot like value investing on a very large scale.
Arnott’s company, Research Affiliates, now has 37 fundamental indexes published by FTSE. They are called the FTSE/RAFI Indexes. In addition, PowerShares now offers the FTSE RAFI US 1500 Small-Mid Portfolio and the FTSE RAFI US 1000 Porfolio, both of which are exchange-traded funds. PIMCO has also started offering a mutual fund called the Fundamental Index PLUS TR (a load fund).
In addition to the RAFI fundamental indexes, there’s also the ETFs offered by Wisdom Tree. Wisdom Tree has been in the news a lot lately. I’m sure a huge contributing factor to this is that they have author Jeremy Seigel as part of their company. Professor Seigel has developed a huge following after the publication of his book, Stocks for the Long Run
Finally, I must mention that not everyone is a fan of fundamental indexing. In fact, one well-respected indexer, John Bogle, wrote an op-ed piece with Burton Malkiel that was not favorable of fundamental indexing.
Who’s right? Which indexing method is superior? I guess time will give us that answer.
RELATED: Here’s a listing of all the ETFs offered by Wisdom Tree to date:
DOMESTIC ETFs
Total Dividend Fund (DTD)
LargeCap Dividend Fund (DLN)
MidCap Dividend Fund (DON)
SmallCap Dividend Fund (DES)
High-Yielding Equity Fund (DHS)
Dividend Top 100 Fund (DTN)
INTERNATIONAL ETFs
DIEFA Fund (DWM)
DIEFA High-Yielding Equity Fund (DTH)
International LargeCap Dividend Fund (DOL)
International MidCap Dividend Fund (DIM)
International SmallCap Dividend Fund (DLS)
International Dividend Top 100 Fund (DOO)
Europe Total Dividend Fund (DEB)
Europe SmallCap Dividend Fund (DFE)
Europe High-Yielding Equity Fund (DEW)
Pacific ex-Japan Total Dividend Fund (DND)
Pacific ex-Japan High-Yielding Equity Fund (DNH)
Japan Total Dividend Fund (DXJ)
Japan High-Yielding Equity Fund (DNL)
Japan SmallCap Dividend Fund (DFJ)
INTERNATIONAL SECTOR ETFs
International Basic Materials Sector Fund (DBN)
International Communications Sector Fund (DGG)
International Consumer Cyclical Sector Fund (DPC)
International Consumer Non-Cyclical Fund (DPN)
International Energy Sector Fund (DKA)
International Financial Sector Fund (DRF)
International Health Care Sector Fund (DBR)
International Industrial Sector (DDI)
International Technology Sector Fund (DBT)
International Utilities Sector Fund (DBU)
Topics: Exchange-Traded Funds, Index Funds, Investing, Mutual Funds |