Fundamental-Weighted Indexes
Fundamental indexes present an investment strategy based on the premise that market prices cannot reliably represent the underlying value of a company, because markets are not efficient. Fundamental indexes weight stocks by business metrics such as sales, cash flows, book value, dividends and buybacks (the so-called “Main Street” factors), rather than by the float-adjusted market capitalization2 of securities.
By weighting stocks on the basis of subjective factors, an index is inherently placing a bet on which companies have greater performance potential than others (see, for example, Blitz and Swinkels). This passive investment strategy has been seen to provide a higher return with lower volatility relative to cap weighting, over sample periods (see Arnott [2005]).
Since fundamental indexes weight securities by a firm’s economic fundamentals, critics argue that this creates a value bias within the index. Companies that invest heavily in future growth will tend to have low earnings and therefore have a smaller weight in a fundamental index. This creates a scenario wherein fundamental indexes overweight value stocks and underweight growth stocks.
Fundamental indexes also have higher turnover than cap-weighted indexes.
Equal-Weighted Indexes
Equal-weighting does not consider any information about the stocks within an index; the only relevant information is the number of stocks in the index. The basis of the equal-weighting approach is to assign a weight of 1/N to each security in an index, where N is the number of securities in the index.
Assume, for example, that you “know” which security is going to be the best performer in the Russell 1000 Index. If you want the best return, you will hold only that security. If you diversify away from that future best-performing security by purchasing any other securities, you will not achieve the best possible return. But since most investors know they don’t have infallible foresight, they diversify in order to make sure they don’t own only the worst-performing security.
Similar motivations for diversification have been noticed in some active managers’ portfolios. Some active managers, in an attempt to diversify across their holdings, tend not to weight their portfolios by market capitalization. As Fabozzi [1998] notes, “… managers tend to not capitalization-weight their portfolios for a variety of reasons. The most often cited reason is related to the manager’s aversion to putting too much money in any one basket (such as IBM)—they want stock name diversification.”
While market-capitalization-weighted indexes provide diversification benefits by providing exposure to every security in the index, equal-weighting provides equal exposure to every company in the index. Figure 1 presents the weights represented by the Russell 1000 cap weight and the Russell 1000 constituent equal weight indexes, grouped by deciles of company size. The largest 10 percent of companies account for 58 percent of the overall weight in the Russell 1000 cap weight index, compared with just 10 percent of the overall weight in the Russell 1000 equal weight index. Equal-weight indexes provide equal exposure to every size decile of the index, while smaller-capitalization securities have very small weights in a cap-weighted index.
