You know what an index fund is, and how it works. Basically. But the actual construction of most traditional index funds might surprise you. The indexes you know and love (the S&P 500® Index, the Russell 1000® Index, etc.)—and the funds that track them—typically use a stock’s market capitalization to determine the stock’s weight in the portfolio. Thus, the bigger a company’s market cap, the larger a company’s weight in an index. Market-cap strategies tend to overweight overvalued stocks and underweight undervalued stocks.
Fundamentally weighted strategies break away from the market-cap approach—and the bias toward overvalued stocks—and instead weight stocks based on economic factors such as sales, cash flow and return of capital to shareholders (stock buybacks and dividend payouts).
A traditional market-cap index and a fundamentally weighted index that focus on the same asset group will typically own similar stocks. But the proportions are quite different, as you can see above. These are the five largest holdings in two indexes that focus on large-cap stocks: one a traditional index, and one that’s fundamentally weighted. The difference in weighting can lead to dramatically different returns over time.
Size and popularity don’t get you anywhere with a fundamentally weighted index. A prime case in point is Apple, the largest stock by market cap in the United States. While that earns Apple the largest weighting in traditional indexes, it does not guarantee Apple a prime position in a large-cap fundamentally weighted index that looks at economic factors.
The chart above shows Apple’s effect on index performance based on its weight in a traditional index versus a fundamentally weighted one. When Apple generated a 65.4% return in 2012, the traditional index slightly outperformed the fundamentally weighted index by 1.2%. However, when Apple’s stock performance struggled in 2013, dropping by 39.5%, the fundamentally weighted index fared better.
Fundamentally weighted strategies have also been effective in emerging markets. Rather than arbitrarily overweighting large multinational companies, fundamentally weighted indexing weights companies based on economic factors. The difference in weighting methodology can lead to dramatic differences in company, country and sector allocations.
Given its unique hybrid construction, a fundamentally weighted strategy can complement a traditional market-cap index approach. There can also be a place for active management, especially for those active managers that have historically done a better job of protecting wealth in falling markets. Constructing a portfolio using these three building blocks is a mix of art and science. Above is a sample stock portfolio that mixes all three components.