Overview of Fundamental Index Funds

by on October 10, 2011

Index funds are a great idea, but with market returns as low as they’ve been, is there something just as safe and cost effective that can offer better returns?  Enter fundamental index funds, a relatively new breed of fund that aims to beat the market and traditional market index funds.  What are they?  How have they performed?  And should you buy them?  We’ll address all three questions:

What are fundamental index funds?

Fundamental index funds are index funds that track a particular market.  However, unlike traditional index funds that weight their investments by market cap, fundamental funds weight their funds based on fundamentals.  The funds can be mutual funds or exchange traded funds (ETFs).  Also, the funds vary in the way that they allocate their weightings, but they typically use such metrics as sales, dividends, net income, book value, cash flow and assets.  Some funds focus on one particular metric and others use a formula that looks at multiple variables to determine the portfolio weighting.

Let’s look at an example of two funds, one being a traditional S&P 500 index fund and one being a fundamental S&P 500 fund.  The traditional fund will base its weightings on market capitalization, the same as the real S&P 500 index.  This means that a $10 billion market cap company would have 10 times the weighting of a $1 billion company.  In the fundamental index, let’s assume they are using earnings for a weighting.  Let’s also assume that the $10 billion company earns $300 million and trades at 33 times earnings, while the $1 billion company earns $100 million and trades at 10 times earnings.  In the fundamental portfolio, the larger company would be weighted at 3 times the $1 billion company ($300 million versus $100 million in earnings).  As you can see, the fundamental index weights the company that is valued with a smaller earnings multiple with a signifcantly higher weighting.  This is only an example with made up figures, but hopefully it will illustrate how using fundamentals rather than market cap can significantly change the weightings.

How have they performed?

There is not a lot of historical data on how these funds have performed, but there is data going back to the mid 2000’s.  To see how they perform it is best to compare them to traditional index funds during the good and bad times.  During the 2008 financial crisis, traditional S&P 500 index funds fell about 35%.  Fundamental funds fell a few percent more.  However, during 2009, when traditional funds rose about 25%, fundamental funds rose by almost 35%.  In early 2011, during volatile times, fundamental funds have slightly underperformed traditional.  In summary, it appears that these funds offer significantly higher returns in the up markets and slightly lower returns in down markets.

Why do they perform like this?  Because traditional funds use market cap to allocate shares, they heavily favor bigger companies and overpriced or popular stocks.  During bad times, people tend to migrate to safety, including large and stable companies.  This likely accounts for the difference in performance during bad times.  In good times, investors start to feel comfortable and begin looking to subsidize their returns with less popular and smaller stocks.  This causes lower priced stocks to rise faster in good times.  This likely accounts for the higher returns during good market times.

Should you buy them?

Our takeaway on these fundamental index funds is that they really do offer good prospects.  The fact they are indexed funds means they are not actively traded and therefore have lower turnover and tax implications.  Also, they have some of the lowest expense ratios and fees of all investments, often close to 0.2%.  Finally, they offer variations from other index funds, which can increase the level of diversification in your portfolio.  And if that isn’t enough, they may even offer long term superior returns.

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