The basic premise of the Fundamental Index™ concept is that when stocks are both selected and weighted in an index by financial measures of company size, the link between pricing errors and weights is broken allowing for maximization of investment returns for a passive investment product. Our original research1 calculated the benefit to eliminating the return drag of capitalization-weighted portfolios at more than two percent over the 43 years tested. However, not all strategies are created equal. This issue of Fundamentals shows how different fundamental weighting methodologies can have dramatic implications for the uninformed investor.
A key provision of an index is its representation of the investor’s opportunity set. Of course, a fundamentally weighted index will never reflect market weights. Rather, it can and should broadly reflect the economic opportunity set available to the investor. In so doing, each company will be weighted by its “economic footprint.”
The same is true for publicly traded companies. Our original research recognized that any single metric of firm size has its own special vulnerabilities, exposing investors to a skewed sample of companies that fails to adequately reflect the economy. Looking at the four metrics of which the FTSE™ RAFI™ Indices are comprised—dividends, sales, profits, and book value—we find:
The RAFI four-factor methodology provides the additional advantages of lower turnover, lower transaction costs, and lower capital gains taxes compared to single metric approaches. A composite measure provides more stable weights, than a single metric measure, particularly if it is based on multi-year measures. RAFI indices will have lower transaction costs and capital gains taxes, key advantages synonymous with index fund investing. In addition, short-term swings in individual metrics caused by business cycle volatility are mitigated by the RAFI methodology, which uses five-year measures of sales, dividends, and cash flow. We believe that a composite measure of four fundamental size metrics—specifically, sales, cash flow, book value and dividends—provides the greatest diversification, broadest cross section of companies within the economy, highest capacity and greatest tax advantages.
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