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Fundamental indexing: a contrarian approach

By: Tom Goodwin, Senior Research Director

With the approach of the holiday season shopping frenzy, we have a perfect opportunity to observe basic human herding behavior as retailers quickly sell out of their hottest items. The fact is, people tend to be drawn to products that are highly promoted and desired by others. The same holds true for stocks as the hype—positive or negative—surrounding a company can drive market prices up or down. In a market-cap weighted index, these price changes are directly reflected in the stock’s weight within the index. But if we construct an index that breaks this link between market price and index weight, what market conditions would affect our new index?

Introduced in 2005, the Russell Fundamental Indexes®, now called the Russell RAFI™ Index Series[1], provide an alternative weighting methodology that is not tied to market prices. Instead, weightings in this index series are derived using a blend of adjusted sales, retained operating cash flow and dividends plus buybacks, all averaged over five years.[2] As we can see below, this approach to indexing has led to a difference in performance from the corresponding market-cap weighted benchmarks year-to-date.

To understand the drivers of this difference in performance we need to consider the main differences in construction of these two types of index. A key element within the construction of the Russell RAFI Index Series is that stock weights do not correspond to price movements. This means that the index weights tend to lean in the opposite direction from active trading—creating an implicit “contrarian” position.

The case typically put forward for contrarian weighting is two-fold. First there is the assertion that there is a tendency for stock prices to revert to their mean or intrinsic value. Market value, after all, is not purely random but tends to gravitate toward an unobserved central tendency. Fundamental indexes give us a way to get closer to that gravitational center, the intrinsic value, by using purely economic measures of a company’s size and success. Second, market participants mayto over-react to news about a stock—leading to the herding behavior we mentioned earlier. In a cap weighted index, these two factors lead to performance drag. That is, as a stock price rises above its intrinsic value, its weighting within the index rises in tandem. Then as the price reverts back to its mean, the performance of the index is dragged down by the falling price of a now overweight stock. The opposite is true for a stock price that falls below its intrinsic value. We can, for example, see this dynamic play out within the Health Care sector of the Russell 1000® Index in 2016.

As we find in the chart below, the Russell 1000 Health Care sector had returns of 15.0% from March through July of 2016. This substantial rise in the sector caused the sector’s weighting in the cap-weighted Russell 1000 to rise from 13.5% to 14.5% over the same period. Then in the period from August through October 2016, Health Care tumbled from its peak by -9.7%. This price drop coupled with the inflated weight for the sector magnified the impact on the cap-weighted index.

Conversely, the weighting of the Health Care sector within the corresponding Russell RAFI index has remained relatively constant in 2016 at around 10%. We can see in the attribution analysis below, that Health Care was a meaningful contributor to performance for the Fundamental Index, accounting for 0.98% of the 1.82% of its excess return over the Russell 1000.

In sum, stocks or sectors that have a strong trend in one direction and then a sharp reversal can result in a performance drag that can adversely affect the performance of cap-weighted indexes. The steadier weighting methodology in a fundamentally weighted index such as the Russell RAFI Index Series means that the performance drag can be minimized. So, this holiday season you might want to consider countering the herd mentality and evaluate a contrarian approach.

To read more on how different weighting techniques can affect index performance, see the FTSE Russell Blog.

 

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[1] Name change as of December 1, 2016.

[2] http://www.ftse.com/products/downloads/Russell_RAFI_Index_Series_Construction_and_Methodology.pdf?894. Also,Goodwin, T. 2012. “The Russell Fundamental Index Series,” Russell Research.

 

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