Fundamental Indexation

A trillion-dollar industry is based on investing in or benchmarking to capitalization-weighted indexes, even though the finance literature rejects the mean–variance efficiency of such indexes. This study investigates whether stock market indexes based on an array of cap-indifferent measures of company size are more mean–variance efficient than those based on market cap. These “Fundamental” indexes were found to deliver consistent, significant benefits relative to standard cap-weighted indexes. The true importance of the difference may have been best noted by Benjamin Graham: In the short run, the market is a voting machine, but in the long run, it is a weighing machine. The insights from the celebrated capital asset pricing model (CAPM) have led many to champion capitalization-weighted equity market portfolios as mean–variance optimal. In response, investment managers and consultants have created a trillion-dollar industry based on investing in passive cap-weighted indexes, such as the S&P 500 Index and other indexes constructed by commercial providers. Trillions more dollars are actively managed and benchmarked against these same cap-weighted indexes, but the CAPM literature already rejects the mean–variance efficiency of cap-weighted equity market indexes. It should be possible, therefore, to construct stock market indexes that are more mean–variance efficient than those based on market capitalization. In pursuing this possibility, we describe a series of equity market indexes weighted by fundamental metrics of size other than market capitalization: book value, trailing five-year average cash flow, trailing five-year average revenues, trailing five-year average sales, trailing five-year average gross dividends, and total employment. We chose these metrics because if capitalization is a “Wall Street” definition of the size of an enterprise, these characteristics are clearly “Main Street” measures. When a merger is announced, the Wall Street Journal may cite the combined capitalization but the New York Post will focus on the combined sales or total employment. We selected companies and their weights in the indexes on the basis of these simple measures using data from the Compustat and CRSP databases. In addition to the individual indexes, we constructed a composite index that equally weights the metrics of book value, cash flow, sales, and dividends. For comparisons, we use the S&P 500 and a “Reference” portfolio constructed as a cap-weighted index of the 1,000 largest stocks by market capitalization. In comparisons, we found that the Fundamental indexes delivered consistent and significant benefits relative to standard cap-weighted market indexes in our sample period, 1962–2004. The Fundamental indexes exhibited beta, liquidity, and capacity that are similar to those of the cap-weighted equity market indexes and had very low turnover. They produced annual returns for the sample period that were, on average, 215 bps higher than equivalent cap-weighted index returns. They contained most of the same stocks found in the traditional indexes, but the weights of the stocks in these new indexes differed materially from their weights in cap-weighted indexes. Although price inefficiency could lead to the observed alpha because capitalization weighting overweights the overvalued stocks and underweights undervalued stocks, the superior performance of Fundamental Indexation may be attributable to superior mean–variance portfolio construction or to hidden risk factors, none of which violates the assumption of price efficiency. Regardless of the exact reason, these Fundamental indexes appear to provide long-term performance superior to that of comparable cap-weighted equity indexes. We find it refreshing that Main Street indexing outperforms Wall Street indexing. The true significance of the difference between these two forms of viewing the stock market may have been best noted by Benjamin Graham: In the short run, the market is a voting machine, but in the long run, it is a weighing machine.