The traditional method of capitalization-weighting indices systematically overweights overvalued stocks and underweights undervalued stocks, assuming any price inefficiency. Since investors cannot observe the true fair value of a company, they cannot remove inefficiency altogether but can remove the systematic inefficiency that is inherent in capitalization-weighted indices. Equal-weighting is one method to remove this systematic inefficiency but suffers from high turnover, high volatility, and the requirement to invest potentially large sums in illiquid stocks.
Weighting by fundamental factors avoids the pitfalls of equal weighting while still removing the systematic inefficiency of capitalization weighting. It weights industries by fundamental factors (also called "Main Street" factors ) such as sales, book value, dividends, earnings, or employees. If a stock’s price gets either too high or too low relative to its fair value, weighting by fundamentals will not reflect this bias. This prevents fundamentally based indices from participating in bubbles and crashes and thus reduces its volatility while delivering a higher return.
If the assumptions of the CAPM do not hold, then the capitalization-weighted market portfolio is not efficient. Assuming any pricing inefficiency, even in the case of random noise, capitalization-weighting is sub-optimal and the degree of sub-performance is proportional to the degree of random noise.
Indices weighted by any of several fundamental factors including sales, cash flow, book value, or dividends in U.S. markets outperformed the S&P 500 by approximately 2% with volatility similar to the S&P 500. Thus, fundamentally based indices also had a higher Sharpe Ratio than capitalization-weighted indices. In non-U.S. markets, fundamentally based indices outperformed capitalization weighted indices by approximately 2.5% with slightly less volatility and outperformed in all 23 MSCI EAFE countries.
Since the first research was disseminated, fundamentally based indexes have been criticized by proponents of capitalization weighting including John Bogle, Burton Malkiel, and Gus Sauter. Responses have come primarily from the publications of one of the founders of fundamentally based indexes, Robert Arnott.
Fundamentally based indices are exposed to the Fama French risk factors—that is they are value-biased and small cap-biased. These factors have historically led to outperformance. The current returns of fundamentally based indices are exaggerated because of the recent strong performance of value stocks.
Fundamentally based indices have higher turnover and therefore higher costs than capitalization weighted indices.
Fundamentally based indices have higher expense ratios than capitalization weighted ones. For example, the Powershares fundamentally based ETFs have an expense ratio of 0.6% while the PIMCO Fundamental IndexPLUS TR Fund charges 1.14% in annual expenses. In comparison, the Vanguard 500 Index Fund charges 0.18% per annum.
The 2 to 2.5% of additional returns that come from fundamentally based indexes are back-tested, and fundamentally based index funds have not been around long enough to draw any conclusions. We cannot know how the strategy will perform in the future.