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Fundamental indexes: Weighting by corporate financials

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. 


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