The Fundamentals of Fundamental Indexing

Should investors consider fundamentally weighted strategies?

Adam McCullough, CFA 22 November, 2018 | 11:35
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Market-cap-weighting reflects all market participants' views, allowing passive investors to free-ride on the collective wisdom of all active investors. But there is a risk that it could also lead a portfolio to overweight the most expensive areas of the market. Fundamental index funds attempt to circumvent this potential problem by severing the link between a stock's portfolio weight and its price. This article explores the investment thesis of fundamental weighting and examines the investment merits of strategies that use this weighting approach. 

Shared Characteristics

Market-cap-weighted indexes are inherently efficient and inexpensive to implement. A stock's weight in a market-cap-weighted index moves with its share price. Investors save on transaction costs because the index's largest positions are naturally the biggest companies with the most-liquid shares. Unlike market-cap-weighted indexes, fundamental indexes size their holdings by metrics such as company revenues, earnings, or dividends instead of share prices.

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About Author

Adam McCullough, CFA  Adam McCullough, CFA, is an Analyst on Morningstar’s Manager Research Team, covering passive strategies.

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