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:
- A dividend-based metric will exclude well over half of all publicly traded companies in the market, including most growth stocks and essentially all emerging growth companies leading to potentially skewed sector allocations. In addition, dividends are a management decision which leads to the following question: should we let a management decision dictate the size of an organization? RAFI methodology deliberately makes a special provision for zero-yield companies. Companies that have paid no dividends in the past five years are weighted equally according to the other three metrics.
- The sales-based metric is not consistently defined across industries. For example, sales are ill-defined in some of the service industries, notably financial services and trading companies. Further, relying only on sales to measure size may over-emphasize companies with lower profit margins.
- A profits-based metric may lead to over- or under-exposure to companies with highly cyclical income. Thus, sizeable deep value or distressed firms may receive little to no weight in a profits-based index.
- A book value metric may lead to over- or under-exposure to companies with aggressive or conservative accounting practices. It may also favor older firms with legacy assets on their balance sheets.
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.