Fundamental Indexing

Cap-Weighting vs Fundamentals-Weighted indices

A market cap index is created by giving weightings to shares according to the company's size (or capitalisation). Its size is determined by multiplying the number of listed shares by its share price. The larger the company's market capitalisation, the larger its weighting in the index. A company's weighting tends to be driven by market supply and demand, i.e. as the market drives share prices higher, their weighting in the index increases.

A fundamental index uses fundamental factors to weight a company, including cash flow, sales, dividends and book value.

Investors Sentiment
Market capitalisation (or price related) indices are significantly impacted by the street's valuation of each counter. These valuations are strongly influenced by perceptions, investor behaviour (fear and greed) and future forecasts or predictions. The indices will therefore often overweight stocks which are overvalued and underweight stocks which are undervalued.

History shows that the probability of overvalued stock's earnings to disappoint on the downside is high, causing the stock to underperform. Conversely, the probability of an undervalued stock's earnings to surprise on the upside is also high, causing the stock to outperform.

By taking a simple average of each company's four financial measures over a five-year period creates a portfolio that is largely representative of today's economy.

Periodic Rebalancing
Cap-weighted indices chase performance by allocating more and more money to recent winners - a momentum strategy. A stock that doubles in price gets double the weight. These indices do not practice periodic rebalancing - preferring to buy high and sell low.

The fundamentals-weighted concept meanwhile avoids return-chasing behaviour. Stocks that double in price are not given twice the weight. The annual rebalance of the index ensures discipline, forcing a tracker portfolio to buy low and sell high. Outperformers are rebalanced back to their economic size and the proceeds invested in counters that have recently performed poorly relative to their intrinsic value.

Less Diversification
In cap-weighted indices, the tendency to allocate more to recent darlings and bypassing re-balancing can lead to a relatively less diversified portfolio in times of bubbles. As economic sectors surge in price, a natural side effect is a more heavily concentrated cap-weighted fund.

Over time, the relative losses of the hugely over-priced sectors will overwhelm the relative gains of the under-priced sectors because the under priced stocks comprise far less of the portfolio.

A great example of this in South Africa is the resource sector weighting in the FTSE/JSE All Share Index. By the end of 1998, financials had outperformed resources by a massive 26% per annum for 11 years! At this stage in the cycle resources were hugely under priced relative to their intrinsic value, yet their index weighting had declined from close to 50% to around 30% in the All Share Index. However, over the next nine-year period resources have out-performed financials by a substantial 16% per annum. The cap-weighted index had unfortunately sold its future winners.