A traditional stock index, like the S&P 500, is market value (or capitalization) weighted, meaning the bigger the market cap of a stock in an index the bigger the chunk of the index that is occupied by that stock. When you put money into the Vanguard 500 Index (VFINX), which benchmarks the S&P 500, more of your money goes into big cap names like Microsoft (MSFT) and ExxonMobil (XOM) then say, Tyson Foods (TSN).
Until recently, the only notable non-market cap weighted index was the Dow Jones Industrial Average, commonly known as the Dow. The Dow is price weighted – stocks with higher prices like IBM (IBM) are “more important” than lower price stocks like Microsoft (MSFT), even though Microsoft is a bigger company by market capitalization.
The so-called fundamental index does things a little differently. It weighs the stocks in its index not by sheer market value, but by factors such as book value, dividends, profits, and other data.
Because of market inefficiencies some companies have market caps that are either higher or lower than they should be, and these inaccurate valuations create a drag on the performance of the market-weighted index. The fundamentalists say that an index weighted toward a real measure of a company’s value will produce greater returns over the long-haul.
"The Fundamental Index reflects a more rational view of a company's success by looking at factors that are reliable signs of a company's strength, such as sales and profits, rather than a narrow view focused simply on how much the market thinks a company is worth," says Bob Arnott, who developed the fundamental indexing concept. "Historical analysis shows that the traditional cap-weighting approach tends to overweight overvalued stocks and underweight undervalued stocks. While conventional indexes mirror the composition of the broad stock market, and so are drawn in by the fads, bubbles and crashes of the market, the Fundamental Index mirrors the composition of the broad economy."
Schwab apparently agrees, announcing the launch of three fundamental index mutual funds. The Schwab Fundamental US Large Company Index (SFLVX), the Schwab Fundamental US Small-Mid Company Index (SFSVX), and the Schwab Fundamental International Large Company Index (SFNVX) are based on the fundamentally weighted FTSE RAFI Index. (They are not the first. WisdomTree is an entire fund company with dozens of new ETFs that was recently created to offer fundamentally weighted indexes to the investing public.)
Charles Schwab calls fundamental indexing the "the most important innovation in passive investing since indexing was popularized in the 1970s", but others aren't so enthusiastic. John Bogle hates the idea, and others call fundamental indexing merely an "investment strategy masquerading as an index.
What's our take?
There are big problems with these newfangled solutions to the market cap weighting issue. The trouble with bubbles and mis-valuations (and resulting poor performance) from market cap weighted indexes won’t magically go away if everybody starts buying stocks based on "real" measures of success, like dividends or earnings - you can have bubbles in fundamentals as well. Bidding up a slow-growth, high-dividend paying stock until the dividend is just a small percentage payout doesn’t make any more sense than paying a triple-digit PE for Cisco (CSCO).
The market tends to favor growth or value for years on end, until that type of company gets overvalued and the other type is positioned to do better going forward. All of these backward looking, anti-growth and mega-cap stock looking investment products will likely underperform the S&P 500 over the next 5-10 years.
A traditional stock index, like the S&P 500, is market value (or capitalization) weighted, meaning the bigger the market cap of a stock in an index the bigger the chunk of the index that is occupied by that stock. When you put money into the Vanguard 500 Index (VFINX), which benchmarks the S&P 500, more of your money goes into big cap names like Microsoft (MSFT) and ExxonMobil (XOM) then say, Tyson Foods (TSN).
Until recently, the only notable non-market cap weighted index was the Dow Jones Industrial Average, commonly known as the Dow. The Dow is price weighted – stocks with higher prices like IBM (IBM) are “more important” than lower price stocks like Microsoft (MSFT), even though Microsoft is a bigger company by market capitalization.
The so-called fundamental index does things a little differently. It weighs the stocks in its index not by sheer market value, but by factors such as book value, dividends, profits, and other data.
The creators of a controversial new fundamental indexing strategy say the fundamental method is a more accurate way to index than traditional market cap weighted indexes.
Because of market inefficiencies some companies have market caps that are either higher or lower than they should be, and these inaccurate valuations create a drag on the performance of the market-weighted index. The fundamentalists say that an index weighted toward a real measure of a company’s value will produce greater returns over the long-haul.
"The Fundamental Index reflects a more rational view of a company's success by looking at factors that are reliable signs of a company's strength, such as sales and profits, rather than a narrow view focused simply on how much the market thinks a company is worth," says Bob Arnott, who developed the fundamental indexing concept. "Historical analysis shows that the traditional cap-weighting approach tends to overweight overvalued stocks and underweight undervalued stocks. While conventional indexes mirror the composition of the broad stock market, and so are drawn in by the fads, bubbles and crashes of the market, the Fundamental Index mirrors the composition of the broad economy."
Schwab apparently agrees, announcing the launch of three fundamental index mutual funds. The Schwab Fundamental US Large Company Index (SFLVX), the Schwab Fundamental US Small-Mid Company Index (SFSVX), and the Schwab Fundamental International Large Company Index (SFNVX) are based on the fundamentally weighted FTSE RAFI Index. (They are not the first. WisdomTree is an entire fund company with dozens of new ETFs that was recently created to offer fundamentally weighted indexes to the investing public.)
Charles Schwab calls fundamental indexing the "the most important innovation in passive investing since indexing was popularized in the 1970s", but others aren't so enthusiastic. John Bogle hates the idea, and others call fundamental indexing merely an "investment strategy masquerading as an index.
What's our take?
There are big problems with these newfangled solutions to the market cap weighting issue. The trouble with bubbles and mis-valuations (and resulting poor performance) from market cap weighted indexes won’t magically go away if everybody starts buying stocks based on "real" measures of success, like dividends or earnings - you can have bubbles in fundamentals as well. Bidding up a slow-growth, high-dividend paying stock until the dividend is just a small percentage payout doesn’t make any more sense than paying a triple-digit PE for Cisco (CSCO).
The market tends to favor growth or value for years on end, until that type of company gets overvalued and the other type is positioned to do better going forward. All of these backward looking, anti-growth and mega-cap stock looking investment products will likely underperform the S&P 500 over the next 5-10 years.