Jason Hsu: Fundamental indexing a weighting game

  • Published: June 27, 2013
  • Runtime: 3:33
The Research Affiliates CIO says fundamental indexing where traditional cap-weighting is discarded offers the upside of active management without the costs.
Fundamental indexes are weighting based on company fundamentals. This contrast against traditional cap-weighted indexes-- where a stock is weighted by its market capitalization within the index portfolio. So the biggest difference is when a stock becomes overvalued, its price runs up and its market capitalization gets larger and larger. In the traditional index, that stock would take on significantly larger weight to do to the older valuation. This does not happen in a fundamental index because the weight of that stock is always directly related to just the fundamental instead of prices. If you think about traditional cap-weighted indexes, the biggest assumption underline a product is that markets are pretty efficient, so indexing to prices is going to give you a sense of old portfolio. The many move away from the assumption of market price efficiency- you'll allow for the possibility that prices are noisy, can be wrong and very wrong from time to time, then weighting by prices- at least the bad outcome. When you weight by fundamental, you don't suffer from the market sentiment that pull those prices up and down. Instead, you just focus on the company fundamental. The result of that is less susceptible to [unk] develops and sectors and in individual stocks. The way we search a failure-- it creates the fundamental index is very simple. It's based on 4 company fundamentals-- the past 5 years of total cash flow, the past 5 years of total dividends distributed, the past 5 years of sales generated and the equity book value of the firm. And we simply equal weight the 4 fundamental metric to create the portfolio. Fundamental indexes are now being used by clients who want to capture a lot of what- active managers whether quantitative or the more contrary in stock pickers are using a strategies to generate out performance so you can capture that within the fundamental index without paying active fees. And so a lot of clients are now moving from active, high-fee products into fundamental indexes, a way of reducing cost while capturing much of the same benefit of active management. We also have clients who are moving from traditional cap-weighted passive where they can, you know, pay slightly higher fee, but still vary index and passive-like in fees while offering the potential to outperform the traditional benchmarks. Fundamental indexes are available for, you know, US large cap, global markets- global markets including emerging markets and have now been extended into the fixed income markets as well. The biggest growth we see right now is for global, all countries products, where you can buy global equities in one basket and naturally get allocations to emerging markets, to the US, to Japan, to Europe, to Asia. That seems to be the trend in the marketplace as investors diversify away from a concentrated home equity portfolio to a more globally diversified exposure particularly diversifying into emerging markets.

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