Traditional market-cap weighted indices have a fundamental flaw.
The fundamentally weighted indices story only goes back as far as the dotcom boom and bust, a mere 10 years. Nevertheless the "fundamentalists'" basic critique of mainstream cap-weighted indices is persuasive. Their argument goes that tracking in cap-weighted indices tends to make investor overweight in the most recent stock market risers and underweight in those stocks that have suffered relative declines in price.
The fundamental moment -- the dotcom bubble
It's not surprising that the dotcom boom brought fundamental-weighting theory to the fore. Particularly in the US, the tech stocks seemed to run away with the major indices; through 1999 they were pushing the Dow and the S&P 500 higher even though most sectors except technology were heading in the opposite direction. With hindsight it seemed that tracking cap-weighted indices was a great way of capturing the mood of the moment.
Fundamental weighting is an attempt at not being overly affected by current prices by focusing on book value, cash flow, dividends and sales instead. The method has been described as a way of capturing company size in a way that does not depend on market capitalisation. Research Affiliates, the method's inventors, demonstrated that a fundamentally weighted index -- had it existed -- would have outperformed the S&P 500 by an average of about 2% a year between 1962 and 2004.
The credit crunch test
How have fundamentally-weighted compared with cap-weighted ones since the beginning of 2008? Although we've been hearing so much about the 2009 bull market, stocks in the developed world are still down since the beginning of last year, but fundamentally weighted indices are down by less than cap-weighted ones. In the case of some markets, such as the US, the difference is substantial.
There is one exception to the superior performance of fundamentally weighted indices -- the UK. A comparison of Powershares FTSE RAFI UK Fund (LSE: PSRU) with iShares FTSE 100 Fund (LSE: ISF) shows very similar performance through the last 22 months with each falling by approximately 20%. This is partly because fundamental weighting wouldn't have spared passive investors from feeling the pain of the UK's over-weight banking sector.
The fundamental ETF case
For investors who are becoming more nervous about the direction of equities, fundamentally-weighted indices are worth considering. Not the least attraction of fundamentally-weighted ETFs is having the work of identifying the companies with good fundamentals done for you.
On the down side, ETFs tracking fundamentally weighted indices do have slightly higher management charges; the expense ratio for the Powershares range is 0.5%. This is partly because tracking a fundamentally weighted index requires considerably more rebalancing than tracking a cap-weighted one.
Much more telling is the small size of most of these funds: the largest -- Powershares FTSE RAFI Europe (LSE: PSRE) -- has a market cap of only £17m and all the others are much smaller. This begs the question of how firm is Invesco Powershares' commitment to continuing these ETFs. The company closed down 19 fundamentally weighted ETFs in May this year. Moreover, although spreads are low, several of these funds experience substantial premiums and discounts to their underlying index.
Just dividends thank you
One variation on fundamental-weighting is ETFs that take just one of the fundamental criteria as their basis -- dividends. In the fundamentally weighted approach the dividend criteria are supposed to reduce volatility in bear markets although the dividend criteria also have the disadvantage that they act as a drag on the index during bull markets.
For UK ETF investors there is currently a choice of just two: iShares Dow Jones Euro STOXX Select Dividend (LSE: IDVY) and iShares FTSE UK Dividend Plus (LSE: IUKD). The Dow Jones Euro STOXX Select Dividend fund comprises 30 of the highest dividend paying stocks in the euro zone while the FTSE UK Dividend Plus fund tracks the 50 best dividend-paying stocks out of the largest 250 stocks in the UK.
Since the beginning of 2008 these two ETFs have performed worse than their cap-weighted peers in bad times and good. The FTSE Dividend Plus ETF has dropped 37%. While the iShares DJ Euro STOXX Dividend ETF has performed only slightly worse (37% down since January 2008) than the Dow Jones Euro STOXX 50 index (down 33% in the same period) this is due to solely to having sterling as its trading currency. The euro versions of this ETF have fallen by 46% since the beginning of 2008.
The problem with funds that focus on dividends is that the share prices often falls furthest before a company cuts its dividend and the stock ceases to be a constituent of the fund, which then misses out on any recovery in the share price. Of the ten FTSE 100 companies with the highest dividend yields in February, only five are constituents of iShares FTSE UK Dividend Plus at present. The lesson from this seems to be that the volatility proofing qualities of companies with a record for good dividends don't survive severe financial crises.
For investors who don't believe the stock market recovery has much further to run and that dividend cuts are (mostly) over, these dividend funds could be attractive. As for Powershares' range of ETFs that track fundamentally weighted indices, although the concept seems attractive, except for Powershares FTSE RAFI Europe, all these ETFs are just too small.
Ironically, market capitalisation has the last word after all.
More from Francis Groves:
Francis has shares in Powershares FTSE RAFI Europe.
