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Research Department

November-10-10

A New Paper Debunks the Myth of Fundamental Indexing

A new paper published on the Social Science Network (a Web-based network where a lot of the most rigorous economics and finance papers can be found; registration is required in order to obtain the article for free) studies the relative performance of fundamental indexing, equal-weight indexing and a variety of other quantitative portfolio management techniques which present themselves as alternatives to good old market-cap indexing. The paper finds that while all the techniques studied produce excess returns above market-cap weighted benchmarks, none of them produce any alpha (excess return) when they are analyzed with the Fama-French 3-factor methodology. In other words, fundamental indexing excess returns are not the result of superior portfolio engineering that exploits market inefficiencies, but rather the result of higher exposure to riskier value and small-cap stocks. These results are not surprising, as several authors have highlighted this possibility in the past. But the surprise is that the paper was published by Research Affiliates LLC, the very firm that has promoted for many years fundamental indexing, claiming it is all about exploiting market inefficiencies.

The paper also warns the readers about the risk of experiencing higher trading costs due to the higher turnover entailed by these so-called “alternative index strategies”. Not surprisingly, the paper found that fundamental indexing produced by far the lowest turnover rate among all the portfolio management techniques studied. I would like to mention that another alternative technique (not covered by the study) aiming to capture the market return with a value and small cap tilt is provided by Dimensional Fund Advisors. Please find below the turnover history of two closely comparable Canadian Equity Funds: the Claymore Canadian Fundamental Index ETF (using fundamental indexing) and the DFA Core Canadian Equity Fund (proprietary methodology).

A similar comparison between the Claymore and DFA Canada US and International Equity funds deliver the same evidence: DFA Core Equity methodology provides a small cap and value-tilted portfolio with far lower portfolio turnover.

By: Raymond Kerzérho | 0 comments