When most people talk about indices and benchmarks, they are referring to what are known as “Market Capitalization Weighted Indices” or “Cap-Weighted Indices” for short. The TSX and S&P 500 are both cap-weighted indices.
However, there is a “fundamental” flaw with any cap-weighted index. To understand this flaw, first we need to explain how a cap-weighted index is constructed.
The market capitalization of any one company is simply determined by multiplying the stock price by the number of shares outstanding. For example, if Company A has a share price of $10 and there are 1 million shares outstanding, then Company A has a market capitalization of $10 million.
Next, let us imagine we have a fictitious stock market with 100 companies. If we add up all those companies together, we might find that the total market capitalization is $100 million. In this case, Company A would have a 10% weight in this fictitious index because its $10 million market capitalization is 10% of the total $100 million market capitalization of the entire index.
So what's the problem?
The problem is that anytime a company is overpriced (think Nortel during the tech bubble), it will dominate your cap-weighted index fund. This is because its price has increased (due to the market mis-pricing it due to euphoria or speculation), therefore its market capitalization has increased too. In other words, you would now own more of the companies you would want to own less of.
Conversely, sometimes companies are underpriced. Think of all the Canadian banks during the depths of the Credit Crisis. Many of them may have traded well below their fair value prices due to the incredible fear of financial stocks during the Credit Crisis. They all recovered tremendously, but with a cap-weighted index you would have been left behind as the weights of those stocks would have been decreased due to their low share prices. Again, at their lows, when you would have most wanted to buy them, the share prices were low, therefore the market-capitalizations were low, and hence their weightings in a cap-weighted index fund were also low.
To sum it up, anytime you weight an index according a cap-weighted method you will magnify your exposure to overpriced companies (bad) and decrease your exposure to underpriced companies (also bad).
The Fundamental Index
A Fundamental Index corrects for this error by calculating portfolio weights based on fundamental metrics as opposed to stock price. The FTSE RAFI methodology (Financial Times Stock Exchange & Research Affiliates Fundamental Index) is a patented passive investment strategy that looks at the following four items for determining portfoio weights:
1. Free Cash Flow
2. Gross Dividends Paid
3. Book Value
4. Gross Sales
Note that none of these four metrics has any link to a stock's price. Rather, they are all taken from the audited financial statements from the companies in the index.
What you are left with, generally, are the same companies from the cap-weighted index. The major difference is that you no will longer increase the weight of overpriced stocks, and you no longer decrease the weight of underpriced stocks.
It is important to note that you do not eliminate pricing errors. They will continue to exist. But it is more important to note that your exposure to these pricing errors are now completely randomized. This is in stark contrast to a cap-weighted index in which your exposure to pricing errors is magnified to work against you.
Click here to download the original academic paper: Fundamental Indexation.
Click here to compare your mutual funds to a Fundamental Index.
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