Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 147

Fundamental indexing over the cycle

Due to the tendency of stock prices to over and undershoot fundamentals over the economic cycle, both finance theory and empirical evidence suggests that ‘fundamentally weighted’ equity indices (FWIs) should, over time, outperform more traditional market-cap weighted equity indices (MCWIs). It’s also the case that FWIs endure periods of underperformance, usually arising when ‘momentum’ rather than valuation-based ‘regression to the mean’ is driving market performance.

Contrast cap-weight index and fundamental-weight index

As should be clear, MCWIs weight stocks according to their price-based market capitalisation. If the combined capitalisation of stocks in the S&P/ASX 200’s Index was $1.5 trillion, and company X had a market capitalisation of $150 billion, its weight in the index would be 10%.

By contrast, a FWI weights stocks according to non-price related measures of economic importance. In the case of the FTSE RAFI Australia 200 Index, for example, weights are based on four equally weighted factors: a company’s cash flow, dividends, sales and book value, with the first three of these measures averaged over the previous five years, and the last based upon the most recent accounting value.

As seen in the chart below, the upshot of this approach is that FWI’s will tend to be underweight stocks (compared to a MCWI) when their prices are relatively high compared to sales, earnings, book value and dividends, and over-weight these stocks when their prices are relatively low compared to these other non-price measures of a company’s importance.

Regression to the mean

In what’s known as ‘regression to the mean’ in value, to the extent relatively high price stocks eventually tend to underperform, and relatively low priced stocks eventually tend to outperform, finance theory suggests the FTSE RAFI Australian 200 Index should tend to outperform the S&P/ASX 200 over time.

Of course, this theory does not suggest FWIs will necessarily always outperform MCWIs. At least conceptually, the periods of over and under-performance of a FWI are outlined in the diagram below.

This diagram suggests that when stocks with a high price to fundamental value are continuing to outperform (as during the late stages of a speculative bull market at point B) or when stocks with a low price to fundamental value are continuing to underperform (as during the late stages of a bear market when despair is at its most extreme as at point A), FWIs will tend to underperform MCWIs.

FWIs then tend to outperform when beaten down cheap stocks rally relatively strongly in the early stage of a bull market (point C in the chart), and again when expensive stocks fall hardest in the early stage of a bear market (point D in the chart).

Simulated and actual performance

So much for the theory. Whether FWIs outperform MSWIs over time is ultimately an empirical question. Note that the FTSE RAFI Australia 200 Index was launched in August 2009. Index returns prior to launch are simulated based on Research Affiliates’ non-capitalisation weighted indexing system. Actual investment results may differ from simulated results.

As seen in the chart below, the FTSE RAFI Australia 200 Index (simulated plus actual) has tended to outperform the S&P/ASX 200 index over time, though relative performance has nonetheless varied over shorter time periods. Through most of the early 1990s, the RAFI Index outperformed, culminating in a strong surge of outperformance 1998-1999.

Relative Performance: S&P/ASX 200 Index v FTSE RAFI Australia 200 Index: May 1992-December 2015

Source: Research Affiliates and BetaShares. Graph shows performance of FTSE RAFI Australia 200 index relative to S&P/ASX 200 index, not ETF performance and does not allow for ETF management costs. You cannot invest directly in an index. Past performance is not an indicator of future performance of index or ETF.

The most abrupt period of underperformance was during the height of the dotcom bubble between mid-1998 and early 2000. But the Index then again outperformed as tech stocks crashed.

Recent RAFI underperformance

More recently, the RAFI Index has underperformed again, with a return of only 0.4% in 2015 compared to 2.6% for the S&P/ASX 200 Index. RAFI underperformed largely due to two factors: an overweight sector exposure to the underperforming resources sector, and an underweighting to the strongly performing health care sector.

In view of these cycles in relative performance, perhaps the most important statistic is that since the early 1990s, the since-inception outperformance of the RAFI Index over the S&P/ASX 200 Index has been 2.1% p.a.

Notwithstanding the recent underperformance, both finance theory and empirical evidence supports the view that the fundamental indexation strategy has the potential to add value to an investor’s portfolio.

 

David Bassanese is Chief Economist at BetaShares, a leading provider of ETFs. This article is for general information purposes only and neither Cuffelinks nor BetaShares are tax advisers. Readers should obtain professional, independent tax advice before making any investment decision.

BetaShares currently has two ETFs which track indices based on the RAFI fundamental indexation methodology – the BetaShares FTSE RAFI Australia 200 ETF (ASX: QOZ) and the BetaShares FTSE RAFI U.S. 1000 ETF (ASX: QUS).

 


 

Leave a Comment:

     

RELATED ARTICLES

The challenges of building a lazy portfolio

Global ETFs: insights into a multi-trillion-dollar industry

Australian ETFs: end of year reviews 2018

banner

Most viewed in recent weeks

2024/25 super thresholds – key changes and implications

The ATO has released all the superannuation rates and thresholds that will apply from 1 July 2024. Here's what’s changing and what’s not, and some key considerations and opportunities in the lead up to 30 June and beyond.

The greatest investor you’ve never heard of

Jim Simons has achieved breathtaking returns of 62% p.a. over 33 years, a track record like no other, yet he remains little known to the public. Here’s how he’s done it, and the lessons that can be applied to our own investing.

Five months on from cancer diagnosis

Life has radically shifted with my brain cancer, and I don’t know if it will ever be the same again. After decades of writing and a dozen years with Firstlinks, I still want to contribute, but exactly how and when I do that is unclear.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

Welcome to Firstlinks Edition 552 with weekend update

Being rich is having a high-paying job and accumulating fancy houses and cars, while being wealthy is owning assets that provide passive income, as well as freedom and flexibility. Knowing the difference can reframe your life.

  • 21 March 2024

Why LICs may be close to bottoming

Investor disgust, consolidation, de-listings, price discounts, activist investors entering - it’s what typically happens at business cycle troughs, and it’s happening to LICs now. That may present a potential opportunity.

Latest Updates

Shares

20 US stocks to buy and hold forever

Recently, I compiled a list of ASX stocks that you could buy and hold forever. Here’s a follow-up list of US stocks that you could own indefinitely, including well-known names like Microsoft, as well as lesser-known gems.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Property

Baby Boomer housing needs

Baby boomers will account for a third of population growth between 2024 and 2029, making this generation the biggest age-related growth sector over this period. They will shape the housing market with their unique preferences.

SMSF strategies

Meg on SMSFs: When the first member of a couple dies

The surviving spouse has a lot to think about when a member of an SMSF dies. While it pays to understand the options quickly, often they’re best served by moving a little more slowly before making final decisions.

Shares

Small caps are compelling but not for the reasons you might think...

Your author prematurely advocated investing in small caps almost 12 months ago. Since then, the investment landscape has changed, and there are even more reasons to believe small caps are likely to outperform going forward.

Taxation

The mixed fortunes of tax reform in Australia, part 2

Since Federation, reforms to our tax system have proven difficult. Yet they're too important to leave in the too-hard basket, and here's a look at the key ingredients that make a tax reform exercise work, or not.

Investment strategies

8 ways that AI will impact how we invest

AI is affecting ever expanding fields of human activity, and the way we invest is no exception. Here's how investors, advisors and investment managers can better prepare to manage the opportunities and risks that come with AI.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.