This note explores how the tendency of individual stocks and industry sectors to both overshoot and undershoot their fundamental values over time can affect the performance of traditional market-cap weighted equity indices (MCWIs) relative to “fundamentally weighted” indices (FWIs). By seeking to avoid the tendency of MCWIs to overweight stocks that are “overvalued” and underweight stocks that are “undervalued”, financial theory suggests FWI’s should be able to achieve superior long-term return performance relative to MCWIs. What’s more, Australian and US evidence backs up this proposition.
Market Cap vs. Fundamentally Weighted indices
As the name implies, a MCWI weights stocks according to their price-based market capitalisation. If the total market value of stocks within an index is $100 billion, and company X has a valuation of $3 billion, its weight in the index would be 3%. Should the share price of company X rise strongly – raising its relative market capitalization – its weight in the index would also increase.
By contrast, a FWI weights stocks according to other measures of company size – such as sales, dividends, book value and cash flows. If total book value of stocks within an index was $100 billion, for example, and company X had a book value of $2 billion, its weight in a FWI based on book value alone would be 2%. In this example, and as seen in the chart below, companies with lower price-to-book values would have a higher weight in FWI’s compared to MCWI’s.
To the extent fundamental measures such as price-to-book value tend to be mean-reverting, however, this means that FWIs would tend to be overweight stocks (compared to MCWIs) which were relatively “cheap” on this basis – and so inclined to price outperformance. Similarly, FWI’s would tend to be underweight stocks which had relatively high price-to-book values, and so prone to price underperformance.
Current Application: Financials vs. Resources
As seen in the chart below, as at 31 March 2015, the FTSE RAFI Australia 200 index – which weights stocks based on measures such as sales, dividends, book value and cash flows – had an underweight of almost 4% in financial stocks relative to the market-cap weighted S&P/ASX 200 index. By contrast, the RAFI index was overweight materials stocks by just over 3% compared with the S&P/ASX 200 index.
These weighting differences clearly reflect the relatively strong share price performance of financial stocks in recent years compared to other measures of financial sector valuation such as dividends, book value, cash flows and sales. By contrast, the price performance of materials (largely mining) stocks has been relatively poor compared to other fundamental measures of their value.
To the extent there is an element of “overshooting” in these divergent sector price trends, chances are that material stocks will eventually outperform financial stocks as price valuations regress back to more normal levels. Should this happen, the RAFI index – being underweight financials and overweight resources – would tend to outperform the S&P/ASX 200 index, assuming other factors are equal.
Of course, whether a FWI tends to outperform a MCWI is ultimately an empirical question. Even if valuation overshooting is evident among listed stocks and industry sectors, FWIs could still be structured in a way as to fail to benefit from subsequent regression to the mean effects. For example, the evidence suggests the more regularly FWIs are rebalanced and the shorter the historic time frame over which non-price valuation metrics are measured, the performance of FWIs tend to converge to that of MCWIs.
The methodology underpinning the BetaShares Fundamental Index Series for both Australian and US equities is based on annual re-balancing and four non-price company valuation metrics – sales, cash flows, dividends and book value – for the previous 5 years. As seen in the chart below, this methodology has historically produced consistent outperformance for both indices over the longer term compared with the traditional market-cap weighted alternatives.
The FTSE RAFI Australia 200 Index was launched on 10/8/2009 and the FTSE RAFI US 1000 Index was launched on 29/12/2005. Index returns prior to launch are simulated based on Research Affilates’ patented non-capitalisation weighted indexing system, method and computer program product. Actual investment results may differ from simulated results. Past performance is not an indication of future performance.
BetaShares Fundamental Indices
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 FTSE RAFI Australia 200 ETF (ASX code: QOZ), and the FTSE RAFI US 1000 ETF (ASX Code:QUS) respectively.
Both ETFs seek to avoid the potential of market cap indices to overweight stocks that are overvalued, and underweight stocks that are undervalued by breaking the link between price and index weight. As such, they aim to produce superior long term performance compared to using traditional market-cap weighted indices.