Time to Return to Fundamentals?

Index-tracking exchange-traded funds (ETFs) and mutual funds are prized by investors for their diversification, with many offering hundreds, or even thousands, of stocks in a single investment.

Typically, the indexes these funds track are market-capitalization weighted, meaning the proportion of each stock in the index is determined by the total market value of its outstanding shares. Thus, the bigger a company, the bigger its share in the index.

A capitalization-weighted approach works out well for investors when the market's biggest companies produce outsize gains—but such top-heavy exposure can lead to significant losses when big companies struggle. Earlier this year, for example, the valuations of Amazon, Apple, Meta, Microsoft, Netflix, and Alphabet (the parent company of Google) dropped by a combined $2.2 trillion, accounting for more than half of the S&P 500^®'s year-to-date losses.

As the market works through the current bout of uncertainty, these highly valued companies may continue to pull capitalization-weighted indexes down with them. For those looking to mitigate such risk in their portfolios, fundamentally weighted indexing could be a solution.

Fundamentally weighted indexing was born out of the dot-com bust of the early 2000s. Rob Arnott and his colleagues at investment firm Research Affiliates hoped to remedy what they saw as a popularity contest gone wrong. They knew the market's top dogs rarely held their high ground: Only two of the 10 largest stocks in 2000 (Walmart and Exxon Mobil) were still in the top 10 a decade later.

To help identify underpriced securities with growth potential, Research Affiliates proposed weighting the companies in an index by objective fundamental characteristics, such as adjusted sales, dividends, and operating cash flow. A company that generates significant operating cash flow would typically represent a larger portion of a fundamentally weighted index than a firm with little operating cash flow, whereas some of the top stocks in capitalization-weighted indexes—such as Tesla—are known for their relative lack of operating cash flow.

In practice, this approach yields significant differences in the composition of an index. For example, the market-capitalization-weighted Dow Jones U.S. Large-Cap Total Stock Market Index allocates a whopping 6.14% to its top stock (Apple) and 17.88% to its top five holdings—whereas the fundamentally weighted Russell RAFI™ U.S. Large Company Index allocates just 3.95% to Apple and 12.73% to its top five stocks.

The makeup of the market-capitalization-weighted Dow Jones U.S. Large-Cap Total Stock Market Index differs wildly from its fundamentally weighted counterpart.

1. Apple: 6.14%
2. Microsoft: 5.43%
3. Amazon.com: 2.80%
4. Alphabet (Class A): 1.82%
5. Tesla: 1.69%

Total of top 5 stocks: 17.88%

1. Apple: 3.95%
2. Exxon Mobil: 3.21%
3. Chevron: 2.16%
4. Microsoft: 1.89%
5. AT&T: 1.52%

Total of top 5 stocks: 12.73%

_{Source: Morningstar, as of 05/31/2022. For illustrative purposes only.}

That's not to say fundamentally weighted indexing is inherently better than capitalization-weighted strategies. In fact, when the market is in an uptrend, investors typically put money into stocks that are already working for them, which tends to benefit capitalization-weighted approaches. But when the market is struggling to climb or is losing ground, as it has been this year, investors usually focus on stocks that represent the best potential value relative to their financial outlook, which may give fundamentally weighted strategies the edge.

The Dow Jones U.S. Large-Cap Total Stock Market Index outperformed during much of the market's historic bull run (top chart), but recent weakness has favored the Russell RAFI U.S. Large Company Index (bottom chart).

Given this year's market volatility and the concerns of an inflation-induced recession, fundamentally weighted strategies may see stronger performance relative to capitalization-weighted strategies in the coming months.

It's impossible to predict what's going to happen next week, much less next year. So, investors should perhaps consider a mix of fundamentally and capitalization-weighted strategies to help smooth out their returns in their long-term portfolios.