Performance Attribution
The authors recognize that there are four reasons why fundamental indexes outperform cap-weighted indexes. Firstly, the fundamental index is constructed in a way that addresses many problems of the cap-weighted index and, thus, can be considered a superior construct. Indeed, the latter index is based on one factor, whereas the former – is on several variables. Secondly, the stock prices are usually noisy, which negatively affects cap-weighted indexes’ ability to make predictions concerning returns which can lead to negative alphas. For example, the researchers state that one of the reasons for that is that cap-weighted indexes tend to overweight all the overpriced stocks and underweight all the undervalued stocks. On the other hand, fundamental indexes are price-indifferent and, as a result, can better forecast returns. Moreover, it stated that better excess returns of the fundamental index could also be explained by greater exposure to hidden risks, such as risks of distress and liquidity on a macro level. However, the received study results generally do not prove this assumption. Finally, the authors state that all three previously mentioned factors have an impact on fundamental indexes’ better performance.
Summary
Overall, the article under review compared the performance of fundamental-based indexes against cap-weighted indexes. To construct the former index, the authors used such measures of company size as book value, revenues, dividends, employment and sales levels, and revenue. The results revealed that the constructed fundamental index outperformed the cap-weighted index – in this case, S&P500 – by an average of 1.97 pps. a year during the years 1962-2005. This was by four factors, namely better market portfolio construction, inherent price noisiness, greater exposure to hidden risks, and the combination of all the three factors together.
Reference
Arnott, R. D., Hsu, J., & Moore, P. (2005). Fundamental indexation. Financial Analysts Journal, 61(2), 83-99.