Fundamental Analysis

May 08, 2007

Morgan Stanley takes on fundamentally weighted indexes, finds a close correlation to value.

The big question about fundamentally weighted indexing is this: is it really a new idea, or is it just a repackaging of value investing?

It seems like a simple question, but it has sparked some of the most heated debates the index industry has seen in decades, complete with name-calling, threats of legal action and a knock 'em out, drag 'em out public brawl on the op-ed pages of the Wall Street Journal.

Morgan Stanley Global Wealth Management tackled the question in a new research report published on April 23 by Paul Mazzilli and Dominic Maister.

What Is Fundamentally Weighted Indexing?

The idea behind fundamentally weighted indexes is to weight stocks in an index by some "fundamental" measure of value. Traditionally, most market indexes have been weighted by market capitalization; a few have used equal-weighting methodologies; and the most famous market indicator, the Dow Jones Industrial Average, uses a price-weighting system. In general, however, stock market indexes tend to be market-cap-weighted.

Proponents of fundamentally weighted indexing argue that market-cap weighting overvalues the larger stocks and undervalues the smaller stocks, skewing the market. To capture the "true value of the market," fundamentally weighted indexes weight components by dividends, book value, earnings or some other finance-driven metric or combination of metrics.

The Morgan Stanley study examines the performance of some of these fundamentally weighted indexes and similar market-cap-weighted indexes. The report looks at select large-, mid- and small-cap indexes, as well as at broad market indexes, over the periods of 1-, 3-, 5-, 10- and 12-years. All of the indexes considered underlie corresponding exchange-traded funds (ETFs).


One argument regarding fundamentally weighted indexes is that they are skewed to favor value stocks. Because value stocks have dominated for most of the past decade, Mazzilli and Maister added a 12-year period to the study when possible, to see what would happen to the performance statistics if some more growth-dominated years were included.

What did the study find? Well, not surprisingly, it did show that most fundamentally weighted indexes are highly correlated both with each other and with traditional value indexes. However, the value tendency of fundamental ly weighted indexes was not true across the board. Similarly, the study also undermined the assumption held by many that these indexes are uniformly small-cap biased.

Large Cap Indexes

The large-cap indexes examined included the fundamentally weighted WisdomTree LargeCap Dividend Index, the Rydex S&P Equal Weight Index, and the FTSE RAFI U.S. 1000 Index. The WisdomTree index, weighted by dividend distributions, had the highest mean and median market cap of the three, while the FTSE RAFI U.S. 1000 and the S&P Equal Weight index skewed lower.

The performance turned out just about how you would expect for the value-friendly period studied. The study compared the performance of the fundamentally weighted indexes against the cap-weighted S&P 500 and S&P/Citicorp 500 Growth and Value indexes. Over the 12-year period, the three fundamentally weighted indexes all outperformed the S&P 500, with its 11.8 percent return. However, when growth outperformed value, all three indexes trailed the S&P 500.


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