David Koenig serves as Investment Strategist on the Research and Innovation team for Russell Investments’ family of global indexes. In this email interview with SmartBrief, Mr. Koenig discusses fundamentally weighted indexes and how investors are using them.
Question: Smart beta indexes such as fundamentally weighted indexes have seen increasing adoption in recent years. How are these indexes constructed and what are some of their potential advantages?
Answer: Fundamentally weighted indexes select and weight constituents by objective, accounting-based measures of company size such as sales, cash flow and dividends plus buybacks rather than by market capitalization. These could be considered “Main Street” measures of a company’s economic size as opposed to “Wall Street” measures. Fundamentally weighted indexes break the link with price inherent in cap-weighted indexes while retaining the advantages of indexing, such as diversification, transparency, high capacity and relatively low-cost access to equity markets. Because fundamentally weighted indexes anchor constituent weightings to these objective, non-price measures and regularly rebalance back to fundamental weights, they benefit from contra-trading against price movements as markets revert to the mean and correct mispricings over time. This approach can help to lessen the potential impact of market gyrations driven by stock price fluctuations.
Q: Who is using fundamentally weighted indexes and how are they incorporating these strategies into their portfolios?
A: We’re seeing both institutional and retail investors increasingly incorporating fundamentally weighted index strategies as complements to both cap-weighted index strategies and actively managed strategies, often as core portfolios. Institutional investors have been early adopters of smart beta strategies such as fundamentally weighted indexes with about three in 10 institutional plans using smart beta strategies as a portion of the passive allocation within their portfolios. And about half of those who aren’t currently using smart beta strategies are actively researching and considering incorporating them into their portfolios. Additionally, among those institutions that have been using these strategies over the past two years, about two-thirds are increasing allocations over time. Financial advisors and individual investors are also incorporating fundamentally weighted index strategies into their portfolios and we expect to see increasing adoption of these strategies as investors continue to learn how they fit within their portfolios.*
Q: Why does the Russell Fundamental Index® Series use three factors and why are they important for evaluating investments: adjusted sales, retained operating cash flow and dividends plus buybacks?
A: We use these three measures because each is a widely accepted measure of company size, they’re less susceptible to gaming than some other measures and data is easily accessible and available across countries and regions. These three measures are also complementary assessments of a company’s economic size and may diversify sector risks or other potential biases. For example, the sales measure by itself could potentially overweight companies with low margins and low profitability. Likewise, the dividends plus buybacks measure, in isolation, could potentially overweight mature slow-growth companies and underweight expanding and growing companies. Using the three measures together helps mitigate those potential biases.
- Adjusted sales: Determines the amount of sales applicable to common shareholders, adjusted for financial leverage. The adjustment reduces the weighting of highly leveraged companies, helping reduce distress risk and volatility during short-term periods of market stress.
- Retained operating cash flow: The amount of cash available to the company after backing out cash to pay for dividends and stock buybacks. This avoids double counting of dividends and buybacks since they are included as a separate measure.
- Dividends plus buybacks: The effective total amount of cash distributed to shareholders in the form of dividends and stock buybacks. Using this as a standalone measure offers a more complete picture of cash returned to shareholders.
Q: Do you have any specific examples of the potential price sensitivity of cap-weighted indexes relative to fundamentally weighted indexes?
A: A good example would be the price movement of Apple (APPL) stock in 2012 and early 2013. Between February and September 2012, Apple’s stock price rose from $500 to more than $700, a 40% increase in seven months, before rapidly giving up those gains in the subsequent four months. This significant price movement had a much greater influence on the cap-weighted index both on the way up and on the way down than it did on the fundamentally weighted index, where Apple’s weighting represented a smaller and steadier portion of the index throughout the period. A mix of cap-weighted and fundamentally weighted indexes can potentially produce a more diversified market exposure that participates in the upside, protects on the downside and reduces overall price sensitivity.
Q: Are fundamentally weighted indexes meant to replace or complement capitalization weighted indexes? And how do they behave relative to cap-weighted indexes?
A: At Russell, we believe that fundamentally weighted indexes and cap-weighted indexes are well suited as complements. Traditional cap-weighted indexes represent the comprehensive investment opportunity set based on the current expectations of all market participants, making them excellent benchmarks. By definition, they are the market. And we believe that they remain highly relevant as the basis for passive investments. Cap-weighted and fundamentally weighted indexes both offer broad, diversified market exposures, but by holding constituents at different weights they can offer different experiences for investors over time. Cap-weighted indexes reflect the market’s collective future growth expectations and can exhibit a momentum bias, while fundamentally weighted indexes tend to have a value tilt and benefit from reversion to the mean as mispriced securities revert toward intrinsic value over time.
The late 1990s technology bubble helps illustrate environments that might favor cap-weighted or fundamentally weighted indexes. The mega cap, growth-driven market environment during the run-up favored cap-weighted indexes as companies with large capitalizations continued to see price increases and represent a growing percentage of the index weighting. However, when the bubble burst and overpriced stocks fell rapidly back to earth, fundamentally weighted indexes outperformed their cap weighted counterparts. Over the long term, fundamentally weighted indexes have historically outperformed their market cap-weighted counterparts with similar levels of volatility. More information can be found here.
* Sources: Article from Top1000Funds.com: “Pushing smart beta further,” May 29, 2013. Northern Trust “Trends in Alternative Index Use Study, 2013.”
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