WHY FUNDAMENTAL INDEXES ARE SO COMPELLING
By Tom Gartner, CFP®
A new kind of index fund is outdoing the old variety.
Called a “fundamental” index fund, it fixes a longstanding defect of traditional index
portfolios. The traditional variety forces exposure to a lot of hot stocks. Fundamental
indexes place a bigger emphasis on boring but often more profitable stocks.
Over time, fundamental indexes hold up better, at least judging by their short-term
performance and back-testing, which gauges how they would have done if they had
existed in the past. While the fundamental index concept has only been around for a few
years, one of the oldest of this breed offers a convincing argument for why it’s a superior
The PowerShares FTSE RAFI US 1000 (PRF) was up 18.25% annually over the past
three years. Its conventionally constructed benchmark, the Russell 1000 index, rose just
14.93%. The results are similar if we go back five years: The PowerShares offering
increased 1.09% and the Russell 1000, .75%.
Let’s look beneath the hoods of these two different index vehicles to see why the
fundamental kind has an advantage.
Conventional indexes. These are weighted according to market value, also known as
market capitalization or market cap. The Russell 1000, measuring the largest stocks in the
domestic market, gives the most weight to the issues with the largest value, defined as
stock price times the number of shares outstanding.
So in 1999, during the tech boom, Cisco Systems (CSCO) comprised 1.8% of the
Russell index. Cisco was 7% of the tech-oriented Nasdaq Composite index. Cisco was a
very expensive stock then, costing around five times what it does today. So in 1999, the
Internet networking company’s impact on indexes was much bigger than that of most
But the question arises: Is the market’s perception of Cisco’s value the best way to
measure its economic prospects? No, according to Robert Arnott, who heads Research
Affiliates, and originated the concept of fundamental indexes. If fundamental
measurement had been around in 1999, Cisco would have been 0.11% of the Russell.
Fundamental indexes. Arnott, whose firm provides the model for the PowerShares fund,
wanted to focus on what he calls the “true economic footprint” of companies in an index.
In other words, on the fundamental financial factors that drive their fates: sales, profits
and dividends. It’s a way of gauging the health of a business. By his firm’s reckoning,
fundamental indexes tend to beat the Russell 1000 and the Standard and Poor’s 500 by
two percentage points.
In general, smaller stocks in general have more clout in a fundamental index. It is more
difficult for the larger ones like Microsoft (MSFT) to make a 10% move than it is for
Alexion Pharmaceuticals (ALXN), which in the last 12 months has shot up 80%.
Microsoft’s market cap is $236 billion and Alexion’s $14 billion.
During the financial crisis and its aftermath, fundamental indexes showed their strengths
and their weaknesses. In horrible 2008, the PowerShares fund was down 40%, almost
three percentage points worse than the Russell index.
That’s likely due to the extra weighting the PowerShares offering gave to financial
stocks, which were relatively cheap going into the crisis – and suffered severely when the
worst hit. In the 2009 recovery year, however, the PowerShares fund was way ahead,
42% versus 28%.
Even better, such a specially weighted fund can be cheap to own. Fees for the
PowerShares fund are just 0.39% of assets yearly. Other fundamental index funds are
available, also at a bargain rate. Schwab Fundamental Large Company Index
(SFLNX) charges only 0.35%.
Wharton Professor Jeremy Siegel and his partners have a similar approach, with
fundamental funds based on dividends or earnings – WisdomTree Total Dividend
(DTD) and WisdomTree Total Earnings (EXT), both at 0.28%.
The opportunity to have a fund with a strategy that generates a market-beating return,
with super-low fees, is rare and powerful.
Tom Gartner is a financial advisor with ISC Financial Advisors in Minneapolis
This article represents opinions of the author and not those of his firm and are subject to
change from time to time and do not constitute a recommendation to purchase and sale
any security nor to engage in any particular investment strategy. The information
contained here has been obtained from sources believed to be reliable but cannot be
guaranteed for accuracy.