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

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

9 winning investment strategies

There are many ways to invest in stocks, but some strategies are more effective than others. Here are nine tried and tested investment approaches - choosing one of these can improve your chances of reaching your financial goals.

Chinese steel - building a Sydney Harbour Bridge every 10 minutes

China's steel production, equivalent to building one Sydney Harbour Bridge every 10 minutes, has driven Australia's economic growth. With China's slowdown, what does this mean for Australia's economy and investments?

With markets near record highs, here's what you should do with your portfolio

Markets have weathered geopolitical turmoil, hitting near record highs. Investors face tough decisions on valuations, asset concentration, and strategic portfolio rebalancing for risk control and future returns.

Latest Updates

Retirement

The best way to get rich and retire early

This goes through the different options including shares, property and business ownership and declares a winner, as well as outlining the mindset needed to earn enough to never have to work again.

Shares

Boom, bubble or alarm?

After a stellar 2025 to date for equities, warning signs - from speculative froth to stretched valuations - suggest the market’s calm may be masking deeper fragilities. Strategic rebalancing feels increasingly timely.

Property

A perfect storm for housing affordability in Australia

Everyone has a theory as to why housing in Australia is so expensive. There are a lot of different factors at play, from skewed migration patterns to banking trends and housing's status as a national obsession.

Economy

Which generation had it toughest?

Each generation believes its economic challenges were uniquely tough - but what does the data say? A closer look reveals a more nuanced, complex story behind the generational hardship debate. 

Shares

Is the iPhone nearing its Blackberry moment?

Blackberry clung on to the superiority of keyboards at the beginning of the touchscreen era and paid the ultimate price. Could the rise of agentic AI and a new generation of hardware do something similar to Apple?

Fixed interest

Things may finally be turning for the bond market

The bond market is quietly regaining strength. As rate cuts loom and economic growth moderates, high-quality credit and global fixed income present renewed opportunities for investors seeking income and stability. 

Shares

The wisdom of buying absurdly expensive stocks (or not!)

Companies trading at over 10x revenue now account for over 20% of the MSCI World index, levels not seen since the dotcom bubble. Can these shares create lasting value, or are they destined to unravel?

Sponsors

Alliances

© 2025 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.