Fundamental indexing, or “smart beta” is an investing buzz word you might have heard before.  It’s an investment strategy similar to index investing, and was introduced about ten years ago.  Since then the strategy has grown to become rather popular.

Generally, when it comes to new and popular investment strategies I run for the hills.  I learned early on that “this time it’s different” are incredibly dangerous words in the investing sphere.

But even though fundamental indexing is a newer strategy, I believe it merits an allocation in a well diversified portfolio.  This post will explain what fundamental indexing is and why I think you should consider using it.

Before diving into fundamental indexing, let’s take a look at where traditional indexing came from.

Indexing History

Back in the early 1900s there wasn’t much of a market for stocks.  If you wanted to invest in stocks you had to buy physical certificates from someone who had them on hand.  In the big metropolitan areas like New York there were plenty of people wheeling and dealing these certificates (this is how the New York Stock Exchange started).  But even if you could piece together a decent selection, building a well diversified portfolio was overly difficult.

Then in the late 1920s, the first mutual funds appeared.  Established by Massachusetts Investors’ Trust, investors could buy shares of a diversified investment fund managed by a professional for the first time.

The mutual fund market expanded through the 50s and 60s, and by 1970 there were nearly 250 open ended mutual funds available to investors.  These 250 funds were a far easier way for most people to invest, and billions poured into them from around the globe.

They weren’t without their shortcomings though.  The trouble with mutual funds was that investors were forced to put blind faith into an investment manager’s stock picking ability.  The mutual fund manager may be skilled, or they may not.  And since very few investors could have a face to face or phone conversation with a mutual fund manager, many were not completely sold on the idea.

Then in 1971 Wells Fargo Bank started the first index fund.  It was a novel idea.  Rather than trust a stranger to manage your money, you could invest in an index fund that simply replicated a given universe of securities.  S&P 500 index funds simply bought all 500 stocks in the S&P 500.  All the research & analysis a mutual fund manager would undergo to pick superior securities was stripped from the equation.  And since investors didn’t need to pay a mutual fund manager’s salary, index funds were far less expensive.

This was the very idea that John Bogle used to build Vanguard into a massive investment company.  He believed that investors are far better off investing in an index than they are purchasing actively managed mutual funds that attempt to outperform an index.

Bogle also believed that active investment managers were unable to pick outperforming securities (and avoid underperforming securities) on a consistent basis.  Those who did were simply lucky.

The debate between which strategy is superior is fierce, and will probably rage on for eternity. Proponents of active management contend that in the long term, skillful mutual fund managers are still able to outperform index investing.  This might be because they are particularly adept at analyzing securities or the market, or because they have some other type of advantage.

Like Bogle, those arguing in favor of indexing claim that managers who outperform an index do so only by luck, and there is no mutual fund manager alive who can consistently outperform their benchmark index. Therefore it makes no sense to incur the additional cost of active management.

Over the last decade or so, the evidence has pointed toward indexing.  Fewer and fewer mutual funds are outperforming their benchmarks.  And along with more low cost investing options, billions of dollars have flown out of actively managed and into index funds in each of the last 10 years.

Index investing is not perfect either though.  Researchers are starting to question how indexes are composed.  In the S&P 500 for example, the index contains the 500 largest stocks that trade on the U.S. stock market.  It’s weighted by market capitalization, which is the number of shares in existence multiplied by the market price of each share.

Currently Apple has the largest market cap in the S&P 500, with Microsoft, Exxon Mobile, and Johnson & Johnson behind it.  JP Morgan Chase is number ten. So, each share of an S&P 500 index fund contains a higher proportion of Apple than it does JP Morgan Chase.

The argument is that this disparity poses a problem.  Since market cap is partially determined by the price of each stock, cap weighted indexes are subject to the market’s perception of each underlying security.  If the market overvalues a security, index investors end up owning more of the very security that’s being overvalued, and vice versa.

Fundamental indexing seeks to fix this flaw.  First developed by Rob Arnott at Research Affiliates, fundamental indices attempt weight securities by factors that strip out market perception and public opinion.

Rather than use market cap, fundamental indexes use metrics like sales or cash flow.  These are numbers determined by accountants that must comply with generally accepted accounting principles.  Market perception and public opinion of share value are completely stripped out.

After some years of tinkering with the various fundamental factors that could be used to build such an index, Mr. Arnott and his team of economists have refined the field for an array of different indices.

For example, Research Affiliates’ U.S. stock indices utilize adjusted sales, dividends plus buybacks, and retained cash flow. Their international stock indices employ sales, cash flow, dividends, and book value.

Since the idea first surfaced over ten years ago, the investing community has begun to agree with Mr. Arnott’s logic. In 2011 a research paper by Chow, Hsu, Kalesnik, and Little demonstrated how various fundamental indexing strategies produce simulated excess returns compared to their cap-weighted benchmarks over long periods of time.

But as they say, the proof is in the pudding.

Over the ten years Research Affiliates has built fundamental indices, nearly all have outperformed their corresponding cap-weighted benchmarks. The risk adjusted returns from fundamental strategies are also better, based on Sharpe ratios.

The graphs below show comparisons for world stocks, large cap U.S. stocks, developed international stocks, and emerging market stocks.  Research Affiliates’ fundamental strategies for each of these four asset classes outperformed their benchmark on a real and risk adjusted basis over the last ten years.

Growth vs. Value

Here are two other investment strategies you might recognize: growth and value.  In a growth (aka momentum) based investment strategy, the objective is to find stocks that are on the “up and up.”  Your hypothesis in this strategy would be that the security has some kind of new, world changing way of doing things and will continue to appreciate, or run.  Tesla, Netflix, and Amazon are all growth stocks.

Value investing comes from the school of Benjamin Graham and Warren Buffett.  In value investing, your objective is to find mispriced securities.  The hypothesis is that the intrinsic value of a stock is different than where it’s valued in the market.  And over time the market price will revert back to it’s intrinsic value.

In a growth strategy you’re betting on a stock “breaking out.”  In value investing you’re betting on a reversion to the mean.

When you think about it, traditional indexing is reminiscent of growth investing.  The higher the market values a stock, the greater it will be weighted in an index.  The greater it’s weighted in an index, the more an index investor will own.

Fundamental indexing more closely resembles value investing.  Rather than favoring the stocks that are breaking out, a fundamental index weights stocks by intrinsic factors that are unaffected by market perception.

Growth and value are both very popular investment strategies, but most research points to value as being the higher performing in the long run.

This is exactly why you should consider fundamental indexing in your portfolio.  It has the same tax efficiencies and low costs of traditional indexing.  It also omits manager skill from the equation.  Plus, it’s easy to implement the strategy since there are many fundamental index ETFs and mutual funds on the market now.

I don’t believe that you should abandon traditional index investing altogether though.  We should appreciate that there are only ten years of real returns available to analyze fundamental indexing and compare it to traditional indexing.  Simulated back testing and academic theory are helpful, but they’re not a perfect representation of real live markets.

All in all, I think most investors are best off incorporating a healthy mix of both strategies.  Just like value and growth strategies both have a place in your portfolio, so do traditional and fundamental indexing.