August 27, 2013 Leave a comment
In the mid-2000s, in an effort to create less volatile market indices than the prevalent capitalization weighted indices, a dedicated group of experienced investment professionals created a template for fundamentally weighted indices.
The index template they created is based on the economic footprint of each company as opposed to the market weight of each company. The economic footprint is measured by a blend of sales, cash flow, book value and dividends.
In a capitalization weighted index “hot” stocks receive an ever higher weighting in the index as their stock price goes up, often to unsustainable levels. In a “hot” market many stocks rise to these unsustainable levels, leading to sometimes severe sector or general market sell-offs. Conversely, out of favor companies decline in weightings as their stock prices decline. So, as high priced stocks go higher more is added to the index and as low priced stocks go lower more is sold-buy high and sell low.
In an economically weighted index stock weightings are increased or decreased based on the change (smoothed over 5 years to reduce volatility and transaction costs) in the size of the company. So, a stock’s weighting is increased as its sales, cash flow, book value and dividends rise, and its weighting is decreased as these measures decline.
The positive historic returns of nearly all fundamentally weighted indices over capitalization weighted indices is truly compelling. Adding weight to stocks whose economic value is increasing as opposed to their stock prices rising and reducing weightings as the economic footprint decreases rather than a declining stock price seems to lead to consistent outperformance. Let’s take a look at performance in my next post.