Fundamental indexing: Fitting it into an investment portfolio

It’s perhaps no surprise that investors are being increasingly drawn to the benefits of low-cost index investing. Regular industry surveys tend to find that most actively managed (and more expensive) funds, despite their best effort, fail to beat their market benchmarks consistently over time.

So, the advent of index tracking exchange traded funds (ETFs) has made it even easier for investors to add low cost passive exposures to their portfolios.

Given the existence of both passive and active investment opportunities, investors now seem to have three choices when constructing managed fund portfolios:

  1. cling to the use of active funds alone;
  2. switch to the use of low-cost market-tracking funds only; or
  3. mix both active and passive strategies in what’s known as ‘core-satellite’ investing.

That said, there is, in fact, a fourth choice: choose a low-cost passive strategy that can potentially offer some of the return benefits ordinarily only expected from more expensive active strategies.

David Bassanese
Chief economist
Indeed, if we define the ‘market’ as a market-capitalisation weighted index, such as the S&P/ASX 200 Index, it turns out there is a strategy that can offer investors potentially market beating returns over time, whilst still retaining the indexing benefits of transparency and low management cost.

Which strategy? It’s called ‘fundamental indexing’ and it underpins the strategy of two of BetaShares’ flagship Australian and US equity ETFs, the BetaShares FTSE RAFI Australia 200 ETF (ASX Code: QOZ) and the BetaShares FTSE RAFI US 1000 ETF (ASX Code: QUS).

Fundamental factors
As set out below (Chart 1), the BetaShares Fundamental Index ETFs use four equal-weighted measures of company size to determine the index weights.

Chart 1

These factors have been chosen because:

- They reflect a company’s economic footprint and are not price related;

- They are widely accepted indicators of company size, easily accessible and broadly available;

- They are top line accounting measures that are less susceptible to manipulation;

- Five year averaging helps to smooth peaks and valleys in accounting data; and

- The methodology is transparent, repeatable and based on historical measures which have statistically proven to be successful in delivering attractive performance outcomes compared to market cap weighted indices.

Using this indexing strategy, the FTSE RAFI Australia 200 ETF comprises the 200 companies with the largest ‘fundamental values’ amongst companies listed on the ASX. Similarly, the FTSE RAFI US 1000 ETF comprises the 1,000 securities with the largest ‘fundamental values’ amongst US listed stocks.

Fundamental indexing and beating the market

Fundamental indexing works precisely because the traditional approach to indexing suffers from a tendency to overweight expensive stocks and underweight cheap stocks.

How so?

Traditionally, market indices (such as Australia’s S&P/ASX 200 Index or America’s S&P 500 Index) use a market-cap weighting approach. As seen in Chart 2, that means if the price of a stock rises in value, a market-cap index will effectively increase its weighting to the stock – even if the stock’s share price is already arguably overvalued relative to underlying valuations (e.g. Period C).

Similarly, stocks that fall in value will have a reduced weight in the index, even if their price fall was unjustified by fundamentals, and these cheap stocks could be poised to bounce back in the future (e.g. Period A).

By contrast, by simply breaking the link with market price, fundamental indexing seeks to avoid the market-cap weighting problem of overweighting expensive stocks and underweighting cheap stocks. As expensive stocks start to underperform (Period D) and cheap stocks to outperform (Period B), fundamental indexing strategies have tended to outperform market-cap indexing strategies.


Chart 2

Of course, as evident in Chart 2, fundamental indexing does not always outperform – but this is usually during temporary (often speculative) periods when market momentum continues to favour already expensive stocks and disfavour cheaper (better-value) stocks. As and when stock valuations re-normalise, fundamental indices then have the potential to more than make up for their temporary period of underperformance relative to market-cap weighted indices.

The proof is in the pudding: Fundamental indexing performance

When it comes to the benefits of fundamental indexing, I believe the results speak for themselves.

As seen in Chart 3, the FTSE RAFI Australia 200 Index – which, since its launch in July 2013, QOZ has aimed to track – has historically tended to outperform the S&P/ASX 200 Index by around 2 per cent per annum over the long-term. QOZ itself was launched almost four years ago on the Australian market, and up until end-March 2017, its underlying index had produced an annualised return since inception of 11.25 per cent per annum, compared to 9.81 per cent for the S&P/ASX 200 Index. After fees, QOZ has produced a return of 10.72 per cent per annum over this period.

Chart 3

Past performance is not an indication of future performance. The chart shows performance of the Index which QOZ aims to track vs. the S&P/ASX 200 Index and does not take into account ETF fees and expenses. You cannot invest directly in an index.

Not only has the fundamental indexing strategy underpinning QOZ consistently beaten the market historically over the long-term, it has also shown most active managers a clean pair of heels – as might be expected given most active managers haven’t themselves consistently beaten the market according to the research.

Indeed, as seen in Table 1, were QOZ dubbed ‘actively managed’, its performance would have ranked it at number two among the 211 Australian large-cap managers tracked by Morningstar for the one year period ending 31 March 2017. And QOZ would have ranked in the top quartile of active managers on a one year, five year and 10 year basis.


Table 1

Past performance is not an indication of future performance. The table shows performance of the index which QOZ aims to track, less QOZ management costs of 0.40 per cent per annum, compared to active managers using the Australian Equity Large Blend category.

Since its inception in the late 1980s, the FTSE RAFI US 1000 Equity Index has produced an annualised return of 14.3 per cent per annum to 31 March 2017, compared with 12.3 per cent per annum for the S&P 500 Index – an outperformance of 2 per cent per annum.

Chart 4

Past performance is not an indication of future performance. The chart shows performance of the index which QUS aims to track vs. the S&P 500 Index and does not take into account ETF fees and expenses. You cannot invest directly in an index.

Market behaviour over the past year provides a classic example of how fundamental indexing seeks to win out over time.

As seen in Table 2, the fundamentally weighted FTSE RAFI Australia 200 Index started the year effectively ‘overweight’ the resources sector, compared to the market-cap weighted S&P/ASX 200 Index – reflecting the fact resource stocks fared poorly in 2015 and their market capitalisation had fallen relative to underlying measures of value, such as earnings and book value.

To offset this overweight, the fundamental index was underweight health care stocks, which had a strong 2015 and had increased in market capitalisation.

These sector positions help the fundamental index then outperform in 2016, as resources rebounded strongly and health care stocks lagged.

But it was not just sector positioning that helped the fundamental index outperform last year. As also evident, stock weightings within each sector saw sector returns based on fundamental indexing outperform those produced by market-cap indexing in 10 of the 11 industry sectors.

Fundamental indexing does not just produce relative sector tilts based on relative valuation, but also value-based stock tilts within each sector.

Table 2


Fundamental indices: Core or core/satellite approaches to portfolio construction

Given the benefits of fundamental indexing, it does offer an attractive option when seeking to add a low cost passive exposure as a ‘core’ element in one’s portfolio. Not only will such an indexing strategy provide diversified exposure to the broad equity market at relatively low cost, it also offers potential for enhanced returns compared to those of a market-cap weighted strategy, such as a fund that tracks the S&P/ASX 200 Index.

For some investors, such an exposure alone might satisfy their aims – with little need for added investment ‘satellites’. For others, a fundamental indexing strategy could still form the core part of a portfolio, with other satellite exposure being used to provide further favoured tactical tilts to particular sectors, investment themes or active managers.

David Bassanese is the chief economist at BetaShares.

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