Time to Return to Fundamentals?

August 17, 2022 D.J. Tierney
Fundamentally weighted indexing could help your portfolio ride out market turbulence.

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.

Value versus size

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.

Weight list

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

Dow Jones U.S. Large-Cap Total Stock Market Index

  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%

Russell RAFI U.S. Large Company Index

  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.

Comparing performance

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.

Trading places

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).

2017–2019

From January 2017 through December 2019, the Dow Jones U.S. Large-Cap Total Stock Market Index returned roughly 45%, while the Russell RAFI™ U.S. Large Company Index returned 37% over the same period.

Source: Morningstar.

Data from 12/31/2016 through 12/31/2019. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

Early 2022

 From January 1, 2022, through May 31, 2022, the Dow Jones U.S. Large-Cap Total Stock Market Index lost nearly 14%, while the Russell RAFI™ U.S. Large Company Index loss less than a fourth of that, -3%, over the same period.

Source: Morningstar.

Data from 12/31/2021 through 05/31/2022. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

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.

Better together

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.

Log into your account to research funds.

  • For fundamental ETFs, use the ETF Screener, select Weighting Scheme under the Portfolio dropdown, and then select Fundamental. 
  • For fundamental mutual funds, use the Fund Screener, select Search By Name under the Basic dropdown, and then enter "fundamental" in the search field.

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Investors should carefully consider information contained in the prospectus or, if available, the summary prospectus, including investment objectives, risks, charges, and expenses. Please read it carefully before investing.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Supporting documentation for any claims or statistical information is available upon request.   

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

All corporate names are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.

Investing involves risk, including loss of principal. 

Past performance is no guarantee of future results, and the opinions presented cannot be viewed as an indicator of future performance.

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Fundamental Index® is a trademark of Research Affiliates.

The Schwab Fundamental Index Funds are not in any way sponsored, endorsed, sold, or promoted by Frank Russell Company (Russell), by the London Stock Exchange Group companies (LSEG), or by Research Affiliates LLC (RA) (collectively the Licensor Parties), and none of the Licensor Parties makes any warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the Russell RAFI Index Series (the Indexes) or otherwise. The Indexes are compiled and calculated by Russell in conjunction with RA. None of the Licensor Parties shall be liable (whether in negligence or otherwise) to any person for any error in the Indexes and none of the Licensor Parties shall be under any obligation to advise any person of any error therein. "Russell®" is a trademark of Russell. The trade names "Research Affiliates®," "Fundamental Index®," and "RAFI®" are registered trademarks of RA. Charles Schwab Investment Management, Inc., has obtained full license from Russell to use the Indexes. For full disclaimer please see the funds' statements of additional information.  

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