Capitalization-weighted stock indexes arguably incorporate a performance drag by overweighting overvalued stocks and underweighting undervalued stocks. In their February 2009 paper entitled “Fundamental Indexing: An Analysis of the Returns, Risks and Costs of Applying the Strategy”, Roel Houwer and Auke Plantinga examine the raw and risk-adjusted returns of hypothetical indexes of European stocks weighted by dividend, book value, revenue and operating income. They take the capitalization-weighted Stoxx 600 Index as a benchmark. Using monthly stock returns and firm fundamental data for the Stoxx 600, along with relevant risk-adjustment data, for the period 1993-2007, they conclude that:
- The average return of each fundamental index is higher than that of the Stoxx 600 Index (see the chart below).
- The fundamental indexes tilt more toward value (high book-to-market ratio) stocks and small-capitalization stocks than does the capitalization-weighted benchmark index, but the fundamental indexes still outperform after adjusting for market, size and book-to-market risk factors.
- Turnovers for the fundamental indexes are generally much higher than that for the capitalization-weighted benchmark index. However, the fundamental indexes still outperform the the capitalization-weighted index after accounting for reasonable trading frictions.
The following chart, constructed from data in the paper, summarizes the arithmetic mean returns over the period 1993-2007 of five portfolios before accounting for rebalancing costs. One portfolio is a reconstruction of the capitalization-weighted Stoxx 600 Index based on annual rebalancing. The other four portfolios contain Stoxx 600 stocks weighted according to dividends, book value of assets, revenue and operating income as of the end of each calendar year (with operating incomes reset to zero when negative). When any of these fundamentals are not available for a company, the company is excluded from the corresponding index. The standard deviations of annual returns for the fundamental indexes are comparable to that of the Stoxx 600 Index.
In summary, indexes of European stocks weighted by firm accounting fundamentals (dividends, book value of assets, revenue and operating income) significantly outperform a comparable market capitalization-weighted index over the past 15 years.
