Fundamental Index® versus Value Indexes

A reader writes in with a question (I’ve excluded superfluous information):

I had a question regarding the Fundamental Index® Vs Value Indexes.   I am a regular 30 something male who invests for retirement  through a brokerage.  I invest primarily in index etfs by weight cap.  (large US, large Intl, large Cdn, small US, small Intl, Small Cdn, and Emerging markets). I would like to tilt my portfolio towards value, and so I’ve been doing some research on Value etfs.  From what I understand fundamental indexes work similar in theory to value indexes.  Does this mean that when I’m searching for value indexes for my portfolio I could replace it with something like the FTSE RAFI

I’m interested on your thoughts…



Thanks for the question Kenny. (Disclosure: I work for an index mutual fund manufacturer that specializes in the Fundamental Index strategy.)

Your question is a relatively common one. Many people believe that the RAFI strategy is merely a value tilt. While there is certainly a value bias, this bias is dynamic as opposed to static (owing in part to the annual reconstitution). As P/E ratios increase, stock prices increase. This can be independent of fundamental metrics of company size (such as cash flow, dividends, sales and book value as per the FTSE RAFI methodology). The Fundamental Index will reduce exposure to these growth stocks as they continue to rise (assuming nothing has changed on a fundamental basis) and therefore develop a larger value bias as bubbles form. When these bubbles burst, a cap-weighted index can suffer dramatically since weightings to these growth stocks have increased by design. At the same time, the Fundamental Index will reduce its relative value bias. I’m including a link to a newsletter that examines the value tilt of the RAFI 1000 Index overlayed upon a mountain chart that has recorded the 2 year excess rolling returns of value versus growth investment styles. On the right hand Y-axis, you’ll see a scale for the value tilt. “0” represents the value tilt of the Russell 1000 Core index and “1.00” represents the value tilt of the Russell 1000 Value index. This newsletter is a few years old. I’ll ask Research Affiliates for permission to post the updated slide – it’s quite illuminating.

To actually answer your question “Does this mean that when I’m searching for value indexes for my portfolio I could replace it with something like the FTSE RAFI® and it would be a similar investment?”:

Remember, you get what you pay for, and this is all IMHO: You could indeed replace your value indexes with a FTSE RAFI strategy. It would be somewhat similar, as there is pretty much always a value bias but it is important to note that the excess returns of a FTSE RAFI strategy have been shown to be greater than the excess returns of a static value tilted index over the non-value tilted cap-weighted index. There is so much more to a Fundamental Index than the value tilt. I strongly recommend picking up the book “The Fundamental Index” by Robert Arnott, Jason Hsu and John West to really understand it. (Disclosure: this is an affiliate link.)

Preet Banerjee
Preet Banerjee an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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  • Premium Finance

    Amazing read. Interesting take on finances. This is a very important aspect of peoples’ lives nowadays.

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