Considerable recent interest has been shown in a new set of stock-market indices that are weighted by fundamental factors such as sales, earnings, dividends or book values, rather than by capitalization. In this paper, we analyze the performance of Fundamental Indexing™ (“FI”). First, we show that the source of FI’s recent excellent performance is not from its ability to systematically arbitrage mispricing in a noisy market but from increasing the portfolio’s exposure to stocks with low price-to-book values and with small capitalizations. We find that FI does not produce a positive alpha when its excess returns are explained by the Fama-French three-factor model of CAPM beta, the value premium and the size premium. Second, we show that it is possible to construct a portfolio of exchange-traded funds with similar factor loadings that can replicate, and sometimes, even outperform FI. However, we caution investors not to expect consistent outperformance from portfolios tilted towards value and small-cap stocks. Historical data shows evidence of mean reversion in the performance of such strategies.
