Mutual Funds
A Better Way of Indexing?
An interesting one-year-old fund tracks an index based on factors besides company size.
By Steve Savage
Jeremy DeGroot
From Kiplinger's Personal Finance magazine, August 2006
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Our firm is known for identifying skilled fund managers who are able to outperform market indexes over the long term. However, we also believe that investing in index funds is a rational, intelligent approach for investors who lack the expertise, time or interest to select actively managed funds. Most indexes that these funds track, such as Standard & Poor's 500-stock index, base their company weightings on market capitalization, which is stock price multiplied by the number of shares outstanding. But a one-year-old fund that tracks an index and uses alternative measures of company size has piqued our interest. The fund, Pimco Fundamental IndexPlus Total Return (symbol PIXDX), tracks a so-called fundamental index.
New approach
Fundamental indexing is the brainchild of Robert Arnott and his colleagues at Research Affiliates, a California money-management firm. In a paper published last year, they argued that traditional market-cap-weighted indexes tend to overweight stocks that are overvalued and to underweight those that are undervalued. They propose letting a company's economic importance determine its index weighting rather than using its market value, which can fluctuate wildly and is a product of investor emotions and their often-erroneous forecasts.
Arnott constructed an index that ranks 1,000 U.S. stocks by using a combination of cash flow, sales, dividends and book value (an exchange-traded fund that takes a similar approach is PowerShares FTSE RAFI US 1000; see "The New Calculus of ETFs," June). From 1962 through 2004, the fundamental index beat the S&P 500 by about two percentage points per year. Most active fund managers would kill for an edge of two percentage points per year over the S&P 500.
The fundamental index appears to benefit from a heavier concentration in undervalued stocks than you find in the S&P 500 and Russell 1000 indexes. The absence of any forward-looking factors in the fundamental index could result in a value bias. The economic factors used in the index are based on average numbers over the preceding five-year periods or, in the case of book value, the latest reported figures. But what generally moves stock prices are investors' estimates (or guesses) of a company's future earnings. Such estimates don't carry any weight in an index that reflects a company's historical performance.
So young companies and fast-growing companies will be underrepresented in the fundamental index. Recently, for example, the technology and health-care allocation in the fundamental index was eight percentage points less than the allocation in the S&P 500. At the same time, the fundamental index was overweighted in utilities and manufacturing stocks.
Strategy's shortcomings
This potential value bias weakens the case for using a fundamental index as a proxy for the overall stock market. Because it skews its holdings toward bargain-priced stocks, the fundamental index will occasionally lag more-traditional benchmarks, such as the S&P 500. Specifically, it is likely to trail when large, fast-growing companies are in favor. Since 2000, value stocks have dominated the market. But markets move in cycles, and at some point -- maybe soon -- we expect growth stocks to lead the pack again.
It makes sense to look beyond indexes that weight stock positions according to market capitalization, and an index that bases allocations on a company's economic footprint is an intriguing alternative. Investors seeking an index fund with a value bent should consider one that tracks fundamental benchmarks.
Steve Savage and Jeremy DeGroot are partners in Litman/Gregory, which publishes the No-Load Fund Analyst newsletter and also advises the Masters' Select mutual funds (www.litmangregory.com).