Raising the benchmark: How and why fundamentally weighted indices have been outperforming

BY David Bassanese | 1 December 2016

With the rotation out of high priced defensive income stocks in the Australian equity market in recent months – and toward sectors offering relatively better value, such as resources – fundamentally weighted indexing methodologies have again demonstrated their ability to outperform traditional market-cap weighted indices over time.

Dynamic value tilts through a fundamentally weighted index

We have previously discussed the merits of fundamentally-weighted indexing (FWI) methodologies over more traditional market-cap weighted indexing (MCWI) methodologies herehere and here. Essentially, whereas MCWIs use market capitalisation as the basis for attaching weights to stocks within an index, FWIs use non-price sensitive financial indicators of size such as cash flows, book value, earnings and dividends.  As a result, FWIs tend to overweight stocks (relative to their weighting in MCWIs) when their market valuation relative to other non-price indicators of their importance is relatively low, and underweight stocks when their market valuation relative to these other indicators is relatively high.  The weighting differences are illustrated in the diagram below:


To the extent market valuations relative to other non-price measures of value (such a book value or earnings) tend to be mean-reverting, this means that FWIs will tend to outpeform MCWIs when cheap stocks start to outperform and expensive stocks start to underperform. By contrast, FWIs will tend to underperform MCWIs in periods when cheap stocks continue to be punished (i.e get cheaper) and expensive stocks continue to be bought up on momentum (i.e. get more expensive).

Since mid-2015 up until approximately 6 months ago, however, our analysis of these differences has been against the backdrop of strong momentum buying in the Australian market of stocks that could be considered relatively expensive according to traditional valuation criteria – as a result, FWIs have tended to underperform. In recent months, however, value has stormed back into favour, which in turn has helped FWIs outperform once again.

Resource stock rebound helps FWIs

As seen in the table below, the fundamentally weighted FTSE RAFI Australia 200 Index produced a 7.9% return over the four months to end-October, handily outperforming the 2.9% return for the S&P/ASX 200 Index by a full 5%!  Almost half of this outperformance, moreover, was caused by the outperformance of resources stocks relative to other sectors. Indeed, the “basic materials” sector in the S&P/ASX 200 index returned a market-beating 19% over this period, which was particularly beneficial for the FTSE RAFI Australia 200 Index because it had a higher 20.2% weight to the sector, compared to only a 13.2% for the S&P/ASX 200 Index.  What’s more, the fundamentally weighting methodology also produced outperformance within the basic materials sector, with stocks in that sector in the FTSE RAFI Australia 200 index producing a 26% return over the period (compared to 19% for this sector in the S&P/ASX 200 Index).

Other sources of outperformance, though to a lesser degree, were the FTSE RAFI Australia 200’s underweight exposure to the underperforming healthcare and industrial sectors over this period.

Source: MorningStar


Recent FWI outperformance is consistent with the superior historical long-term trend

As seen in the chart and table below, the FTSE RAFI Australia 200 Index has demonstrated superior long-run outperformance compared to the S&P/ASX 200 Index from inception to 31 October 2016. The recent period of outperformance helps to correct for the period of underperformance since mid-2015. To put this performance in context, not only did the FTSE RAFI Australia 200 Index outperform the market-cap weighted benchmark over all periods shown, but, over all these periods, its performance would place it in the top quartile of all Australian active managers investing in the same category according to Morningstar.


Graph and table shows performance of FTSE RAFI Australia 200 index, not ETF performance and do not take into account ETF management costs. You cannot invest directly in an index. Past performance is not an indicator of future performance of index or ETF. The FTSE RAFI Australia 200 Index was launched on 10/8/2009. Index returns prior to launch are simulated based on Research Affiliates’ patented non-capitalisation weighted indexing system, method and computer program product. Actual investment results may differ from simulated result.

 BetaShares Fundamentally Weighted ETFs

BetaShares currently offers Australian investors the choice of two exchange traded funds using a fundamentally weighted indexing methodology, covering the Australian and United States markets.  These are the BetaShares FTSE RAFI Australia 200 ETF (ASX code: QOZ), and the BetaShares FTSE RAFI US 1000 ETF (ASX Code:QUS) respectively.

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