Tuesday, July 19, 2011

Cap-Weighted vs. Fundamental Indexing

Investors have their choice of index method based on either traditional capitalization-weighted funds or fundamentally-weighted funds. The terms used in this battle may be somewhat intimidating, but the ideas are simple enough. The more difficult question to answer is which indexing method will produce higher returns.

Traditional indexes are cap-weighted. For a stock index, this means that each stock is held in the index in proportion to the total value of the company. So if the market says that company A is worth $10 billion, and company B is worth $1 billion, the index will have 10 times as many dollars worth of company A stock as company B stock.

Continuing this example, if a cap-weighted basket of stocks contains $10,000 of company A stock, it will contain $1000 of company B stock. The number of shares may not differ by a factor of 10, though. If A shares trade for $10, then we have 1000 A shares, and if B shares trade for $100, we have only 10 B shares.

The fundamental indexing crowd points to examples like Nortel to say that cap-weighting is crazy. The more overvalued Nortel became, the more dollars worth of Nortel stock was included in the index. This means that wildly overvalued companies tend to dominate index portfolios.

To combat this problem, fundamental indexing came to the rescue. Instead of relying on a company’s current stock price, fundamental indexes use a company’s fundamental factors such as revenues and earnings to arrive at a value for the company. This fundamental value is used to choose the weight of the stock in the fundamental index. Nortel’s share of the index would not have grown so large in a fundamental index because it’s revenue and earnings were low compared to the market’s assessment of Nortel’s total value.

One disadvantage of fundamental indexes is that they require more trading. With cap-weighting, if a company’s stock doubles in price, it’s share of the index roughly doubles and there is no need to buy or sell shares to maintain the cap-weighting. With fundamental indexing, if the share price doubles without any change to the company’s fundamentals, the index must sell off about half of the shares. Similarly, the index must buy more shares when their prices drop. This need for adjustments means that fundamental index funds have higher trading costs than cap-weighted index funds.

If the stock markets do a decent job of valuing stocks, then cap-weighting should win out due to the lower transaction costs. However, if the markets regularly create some high-fliers like Nortel that are destined to crash, then fundamental indexing is likely to benefit by more than its added transaction costs.

I don’t see any way to predict which method will work better going forward. Some back-testing studies indicate that fundamental indexing would have worked well in the past. I tend to be sceptical of any investing strategy that increases costs; so I’ve made my personal bet on cap-weighted indexes, but I have no strong feeling about which will win over the next few decades.