One of the driving forces behind the exploding number of new exchange-traded products (ETPs) is the exploding number of new indexes. And since the bulk of the $1.1 trillion ETP marketplace is still linked to products with underlying indexes, advisors better know their indexes. Do you go with a traditional or fundamental index? Let’s examine this and related questions, and start with some history.
The idea of market indexes dates back to the late 1800s when Charles Dow introduced the Dow Jones Transportation Average (DJTA). Dow calculated the indicator’s value by adding up the closing price of the 11 leading transportation stocks. He used this same calculation method for other barometers, like the Dow Jones Industrial Average (DJIA), which is a collection of 30 blue chip stocks.
Dow’s method is still used today for calculating the DJTA and DJIA and reflects the price of stocks rather than the value of the companies. For instance, a company with a tiny market value could have a $90 stock price while a larger company within the same barometer could have a $9 stock price — yet the smaller company would count 10 times more in the DJTA or DJIA versus the larger company.
Amid recognition of the shortcomings of stock price weighted indicators, value weighted methods began to take hold during the 1950s. A value weighted index calculates the price of each security and multiplies it by the number of shares outstanding.
“This method provides a general price track as well as a valuation yardstick for the wealth of the market or a segment of the market,” explains Richard A. Ferri, in his book titled The ETF Book (Wiley, 2009). “Value weighted indexes are the standard for the measurement of market values around the world.”
While the original thought of benchmark indexes was to provide a way to measure the market’s performance, indexes with alternative weighting schemes were introduced in the late 20th century.
Among this group are equal weighted indexes, which use a simple calculation method by giving each security the same level of representation within the index. This prevents any single security from dominating the overall benchmark’s performance.
In the late 1990s, the idea of “fundamentally weighted” indexes was born. Instead of weighting stocks by their market size or their price, companies were weighted by key financial metrics like book value, dividends, sales, and profitability. Instead of serving as mere yardsticks of the market, the chief aim of this new generation of indexes was to launch investment products like ETFs, in order to give investors building blocks for their portfolios.
The debate between traditionalists, who believe in market cap weighted indexing, and fundamentalists, who don’t, is similar to the perpetual disagreement between Yankee and Red Sox fans about which city has the better baseball team. Depending on the historical time period one examines, one group is right and the other is wrong. And during some periods, both groups can make a strong case.
Even within the fundamental camp there are disagreements about which financial factors produce optimal long-term investment returns.
WisdomTree’s stock ETFs are built around earnings and dividends as their principal weighting factors. On the other hand, the Invesco PowerShares FTSE RAFI indexes use a combination of four fundamental factors, including book value, cash flow, sales and dividends. Each company is selected and weighted within the FTSE RAFI index according to how it produces in each of these four areas.
The table nearby compares the three and five-year performance history of several PowerShares FTSE RAFI ETFs versus their ETF peers that utilize a traditional market cap weighting method. In each category but emerging markets, fundamental indexes recorded a performance advantage. This advantage is most noticeable with the mid and small cap U.S. stock category. Over the past three years, the PowerShares PowerShares FTSE RAFI 1500 Small-Mid ETF (PRFZ) outperformed its competitor, the iShares Russell 2000 ETF (IWM) by a significant margin of 7.86 percentage points.