thinking Content provided by Rusty Vanneman, CLS Chief Investment Officer

What is the difference between a “capitalization-weighted” market index and a “fundamentally-weighted” index? Okay, maybe this question isn’t the top question on most ETF investors’ minds, but I believe in the years ahead, more and more ETF investors will ask this very question. First things first, let’s define these terms. As for “capitalization,” it is basically taking a security’s price times its shares outstanding to find a security’s total capitalization. For example, if a stock has 1,000,000 shares of stock outstanding, and a stock price of $10/share, then its total capitalization would be $10,000,000. Generally, larger companies tend to have larger market capitalizations, but not always. It’s possible, and more common than you might think, that a company without a tremendous amount of revenues, profits or dividends – but with a lot of perceived potential – could have a large market capitalization. That’s where fundamental-weighted indexes come into play. Instead of weighting companies based off capitalization, companies within an equity index will be weighted according to a fundamental factor such as revenues or earnings (dividends and book value are other common fundamental factors). For example, if Company A has twice the revenue as Company B, then its weight in an index will be twice as large. So, is this a better way to think about what represents a “market?”  Is this potentially a better way to think about building portfolios?   I believe “no” is the answer to the first question, but “historically, yes” answers the second. First, what is the market? The market is what captures the total investor experience. How are investor dollars actually invested? In this case, the only way to truly capture “the market” is go with capitalization weighting. It indeed is the best representative of the total investor experience as it captures every dollar invested in it, in proper proportion. Cap-weighting, however, isn’t necessarily the best way to think about building a portfolio. As the leading pioneer in fundamental weighting Rob Arnott said so well in an interview a few years ago:

“If you weight companies in accordance with market capitalization then you are in effect investing more in the companies with the highest multiples, greatest popularity, and the companies that are seen as growth opportunities and have lots of momentum to them. If one wants to invest in a popularity-weighted, growth-tilted, momentum-chasing strategy, then cap-weighting achieves that beautifully. And there is nothing wrong with that; over many years it has performed awfully well, but one can do better. I think the key is to break the link between price of a company and its weight in a portfolio. If the price is high, why should you own more? A lot of these new approaches do break that link and so they have a shared alpha engine in breaking the link between the price of stock and the size of our commitment. Why should we own twice as much just because it doubled in price?” Arnott also stresses that fundamentally weighting a portfolio means “selecting and weighting companies in proportion to the economic footprint of the company (the size of its business) and not its market cap and essentially not what the market thinks will be the future size and success of the company, just how big it is now.”

Fundamental weighting can also be applied to the fixed income markets. In this case, instead of using a cap-weighted market index that essentially overweights the companies that issue the most debt, a fundamental-weighted fixed income benchmark uses fundamental factors such as revenues and earnings. In turn, this emphasizes those bond issuers that have the best fundamentals to pay their debts. As an investor, that’s generally a better way to think about building a bond portfolio. The question remains: does fundamental weighting add value? Leaning on Arnott’s historical studies, a fundamental index applied to high-yield investing added over 3% per year (1997-2011). On the equity side, the value-add relative to cap-weighted indexes was typically 2-4% all over the world. Bottom line, fundamental investing makes intuitive sense, and the historical data backs it up when it comes to performance. In the ETF world, there are more and more fundamentally-weighted ETFs being brought to the market. At present, the fundamentally-weighted equity ETFs have been more popular than their fixed income brethren, but I expect that both will continue to find increased investor usage in the years ahead.