Traditional market cap indices struggle to defend themselves against the accusation that they bloat up on overvalued equities, mechanically shoveling in more of the hot stuff like a compulsive eater – especially when the market is frothy. In contrast, fundamental indices are meant to break this impulse by choosing equities according to a different menu. In the case of the FTSE RAFI ETFs, their index encompasses a broad universe of equities, just like a vanilla index tracker. However the FTSE RAFI indices rank their constituent companies not by market cap, but by four valuation metrics:
Sales
Cash flow
Dividends
Book value
These company ‘fundamentals’ are well known health indicators that transmit information about the underlying state of the business. They are also the source of the value premium, and fundamental indices are tilted in favour of equities that are cheap on those measures.
I'd be interested to hear what you guys think about fundamental indexing. Is it a viable alternative way of fulfilling the stocks component of the PP? Also, I think the article is entertainingly written
The marketing for fundamental indexing seems compelling and it has a certain intuitive appeal -- it does seem logical that market cap weighting does "buy into exuberance" in a sense. That said, the critics label it as camouflaged active management. Additionally, it seems to come at an elevated price. For example, Powershares PRF has an expense ratio of 0.39% and Vanguard VONE (a comparable Russell 1000 ETF) costs 0.12% -- essentially one-third the price. And according to Morningstar, since its inception in 2010, VONE outperforms PRF 45.01% versus 44.73%; the difference is largely explained by the expense ratio difference. Three years of historical performance isn't much, still....
I'm not convinced that fundamental indexing is worth the effort until/unless the expense ratios equalize.
