As discussed yesterday, there are actually many variants of fundamental indexation out there and most are based on single metrics. For example, Jeremy Siegel of “Stocks For The Long Run” fame has teamed with Wisdom Tree to produce ETFs that index on either a dividend weighted basis, or an earnings weighted basis. FTSE RAFI (to my knowledge) is the only one that uses multiple metrics – four to be exact: 1)Sales, 2) Cash-Flow, 3) Book Value and 4) Dividends.
It’s probably helpful to go over how a cap-weighted index (vernacular for Market Capitalization Weighted) is constructed. If we had 100 companies in a market, and the total sum market capitalization of all the companies put together was $100 Billion, then if Company 1 had a market cap of $4 Billion, it would have a 4% weighting in a cap weighted index. If Company 100 had a market cap of $50 million it would have a weighting of 0.05% in the cap weighted index.
To weight on fundamentals is very much the same process, you just use different numbers. So let’s say our 100 companies have combined sales of $100 Billion, and Company 1 had sales of $2 Billion. In the sales-weighted index it has a weighting of 2%.
With FTSE RAFI there’s a bit more to it. You do the same for Cash-Flow, Book Value and Dividends. You then take the average of the four weightings to create a composite weighting. (If a company does not pay dividends, then you take an average of the first three only.) There’s one more step: you then take the rolling 5 year average of this composite to create the final FTSE RAFI Weightings (the index is reconstituted once per year, based on receiving all the audited annual financial statements for the market constituents once per year).
So you can see, none of these metrics or calculations have anything to do with the stock market price – therefore the structural link between portfolio weight and pricing error is removed. Pricing errors still occur, but the point is that they are random and they cancel each other out – instead of having most of your over-pricing errors magnified and most of your under-pricing errors diminished.