Invest Skeptically

The most familiar indices, such as the S&P 500, are typically weighted by market capitalization (a notable exception being the DJIA which is an arithmetic average price). This means that larger companies like 3M get a proportionally larger weighting than smaller stocks like Paychex (just picked two companies at random). Market cap indices are the standard.

However, there is an alternative means of weighting companies in an index based on fundamentals. WisdomTree has launched a family of ETFs based on their fundamental weighted indices. These are weighted by either dividend or earnings yields and founded on the so-called “Noisy Market Hypothesis”. That is, while the market may be efficient on average, and in the long-run, there are times when prices deviate from their “true” value for sustained periods.

Much work has been done on this subject by Robert Arnott and his team at Research Affiliates. In, Fundamental Indexation (Financial Analylsts Journal, March/April 2005, v 61, n 2) Arnott, Hsu and Moore, present a compelling case for using index weights based on fundamentals.

The belief is that “prices are too noisy relative to fundamentals” and, consequently, cap weighting “gives additional weight to stocks that are currently overpriced” relative to their true value and “reduces weights in stocks that are currently trading below” their true value.

Jason Hsu has also published a detailed mathematical description of this in, Cap-Weighted Portfolios Are Sub-Optimal Portfolios (Journal of Investment Management, 2006, v 4, n 3).

The theory is very compelling and while doing some quick Googling today it was hard to find any strongly argued objections, however, Tom Coyne writes (via SeekingAlpha) that he’s skeptical that any advantage from fundamental indexing will be persistent.

For further overview of this topic I found this entry by Brad Zigler on Seeking Alpha.