Using Firm Fundamentals to Build Better Stock Indexes

Do conventional market capitalization-weighted stock indexes suffer from a long-term buy-high/sell-low performance drag when adding and deleting stocks? In their October 2023 paper entitled “Reimagining Index Funds”, Robert Arnott, Chris Brightman, Xi Liu and Que Nguyen construct alternative indexes that select stocks based on fundamental measures of underlying firm size and then weight them by market capitalization (Fundamental-selection Cap-weighted, FS-CW). Specifically, the each March:

• For each firm, calculate four fundamental measures of firm size as percentages of aggregate values for all U.S. firms:
  1. Current book value adjusted for intangibles.
  2. 5-year trailing average sales adjusted for the equity-to-asset ratio.
  3. 5-year trailing average cash flow plus R&D expenses.
  4. 5-year trailing average dividend plus share repurchases.
• For each firm, average these four measures.
• Rank stocks of these firms based on their respective averages.
• Reform equal-weighted indexes of the top 500 (FS-CW 500) or the top 1000 (FS-CW 1000) stocks.

For perspective, they also reform at the end of each June a portfolio of the top 500 stocks selected purely based on market capitalization (True CW 500). They then compare returns and 4-factor (adjusting for market, size, book-to-market and momentum) alphas of the Russell 1000, True CW 500, FS-CW 500 and FS-CW 1000 measured relative to the S&P 500. Using monthly data as described above for all publicly traded U.S. stocks, S&P 500, Russell 1000 and the four stock factors to support backtesting from July 1991 through December 2022, they find that: (more…)