The recent rise of alternatively weighted indexes is well documented, and one of the more popular subsets of this index universe is the fundamental index. Unlike traditional market capitalization weighted indexes, the fundamental index does not use stock price as its primary determinant of constituent weights. Instead, fundamental indexes seek to mitigate the potential concentration concerns of cap-weighted indexes and weight companies by their economic footprint or fundamental size.
FTSE teamed up with Research Affiliates in 2005 to create the FTSE RAFI Fundamental Index Series. The FTSE RAFI series uses sales, cash flow, book value and dividends as the basis for weighting index constituents. A fundamental score is calculated for each company using these factors, and companies are ranked in descending order by score and assigned a commensurate index weight. The indexes are rebalanced annually.
A closer look at index performance sheds light on how fundamental and cap-weighted indexes can differ. Fundamental indexes may generate higher returns with slightly lower volatility., and research published by the Cass Business School in 2013 in which they showed that a variety of alternatively weighted indexes, including both heuristic and risk-based approaches, would all have produced a better risk-adjusted performance outcome than a capitalization-weighted benchmark over the period from 1968 to 2011.
An actual performance comparison of the FTSE RAFI US 1000 and the cap-weighted FTSE USA or FTSE US All-Cap tells a similar story. Over the 8-year period ending 12/31/13, the FTSE RAFI US 1000 Index demonstrated higher performance than both indexes by an average of over 130 basis points per year.
Index composition during volatile markets is another key differentiator between fundamental and cap-weighted indexes. As stocks continued to fall during the financial crisis in 2008/2009, the market cap of financial companies dropped to a greater degree than the overall market. As a result, financial stocks became a smaller percentage overall in cap-weighted index constitution.
The opposite occurred in the fundamentally weighted FTSE RAFI US 1000. While the relatively poor performance of the financial sector led to a downward drift in its weighting, the rebalancing of the index according to factors independent of market capitalization had a countervailing effect. The 2009 FTSE RAFI US 1000 rebalance review assigned an increased target weighting to financials. This rebalance resulted in a financials weighting double that of the cap-weighted FTSE USA Index.
© 2015 London Stock Exchange Group companies.
London Stock Exchange Group companies includes FTSE International Limited (“FTSE”), Frank Russell Company (“Russell”), MTS Next Limited (“MTS”), and FTSE TMX Global Debt Capital Markets Inc (“FTSE TMX”). All rights reserved.
“FTSE®”, “Russell®”, “MTS®”, “FTSE TMX®” and “FTSE Russell” and other service marks and trademarks related to the FTSE or Russell indexes are trademarks of the London Stock Exchange Group companies and are used by FTSE, MTS, FTSE TMX and Russell under license.
All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by the London Stock Exchange Group companies nor its licensors for any errors or for any loss from use of this publication.
Neither the London Stock Exchange Group companies nor any of their licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell Indexes or the fitness or suitability of the FTSE Russell Indexes for any particular purpose to which they might be put.
The London Stock Exchange Group companies do not provide investment advice and nothing in this communication should be taken as constituting financial or investment advice. The London Stock Exchange Group companies make no representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the London Stock Exchange Group companies. Distribution of the London Stock Exchange Group companies’ index values and the use of their indexes to create financial products require a license with FTSE, FTSE TMX, MTS and/or Russell and/or its licensors.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back-tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.