Capitalisation-weighted indexes provide the basis for passive investment strategies designed to capture market performance. However, these cap-weighted indexes are claimed to be sub-optimal because of their tendency to overweight overvalued shares and underweight undervalued shares. U.S. evidence suggests that fundamental indexes, which select, rank and weight stocks according to fundamental measures of size such as book value and revenue, outperform cap-weighted indexes. This study examines fundamental indexation in an Australian context over the period 1995 to 2006 and finds support for the U.S. results. However, we also find that the superiority of fundamental indexation is largely explained by its inherent bias towards value stocks, which raises the question as to whether a more overt value tilt may not provide a superior means for exploiting mispricings in markets.
Arnott, R. D.Hsu, J. C. & Moore, P.2005, ‘Fundamental indexation’, Financial Analysts Journal, vol. 61, no. 2, 83–99.
2.
Arnott, R. D. & West, J. M. 2006, ‘Fundamental Indexes™: Current and Future Applications’, available: http://www.researchaffiliates.com/pubs/pdf/ETF_FA_06_Arnott.pdf.
3.
Australian Securities Exchange, The 2007, S&P Australian Indices: Index Methodology, available: www.asx.com.au, accessed: 13 June, 2007.
4.
Banz, R. W.1981, ‘The relationship between return and market value of common stocks’, Journal of Financial Economics, vol. 9, pp. 3–18.
5.
Berk, J. B.1994, ‘An empirical re-examination of the size relation between firm size and returns’, working paper, University of British Columbia, August.
6.
Berk, J. B.1997, ‘Does size really matter?’Financial Analysts Journal, vol. 53, no. 5, pp. 12–8.
7.
Bird, R., & Casavecchia, L.2007, ‘Sentiment and Financial Health Indicators for Value and Growth Stocks’The European Journal of Finance, Vol. 13Issue 8, pp. 769–793.
8.
Carhart, M. M.1997, ‘On persistence in mutual fund performance’, Journal of Finance, vol. 52, no. 1, 57–82.
9.
Fama, E. F., & French, K. R.1992, ‘The cross-section of expected stock returns’, Journal of Finance, vol. 47, no. 2, 427–65.
10.
Fama, E. F., & French, K. R.1993, ‘Common risk factors in the returns on stocks and bonds’, Journal of Financial Economics, vol. 33, pp. 3–56.
11.
Hemminki, J., & Puttonen, V.2008, ‘Fundamental indexation in Europe’. Journal of Asset Management, vol. 8, no. 6, 401–405.
12.
Hsu, J. C.2006, ‘Cap-weighted portfolios are sub-optimal portfolios’, Journal of Investment Management, vol. 4, no. 3, 1–10.
13.
Hsu, J. C., & Campollo, C.2006, ‘New frontiers in index investing: An examination of fundamental indexation’, Journal of Indexes (Online serial), available: www.researchaffiliates.com/pubs/pdf/newFrontiers.pdf
14.
Jegadeesh, N., & Titman, S.1993, ‘Returns to buying winners and selling losers: Implications for stock market efficiency’, Journal of Finance, vol. 48, no. 1, 65–92.
15.
Jegadeesh, N., & Titman, S.2001, ‘Profitability of momentum strategies: An evaluation of alternative explanations’, Journal of Finance, vol. 56, no. 2, 699–720.
16.
Jensen, M.1968, ‘The performance of mutual funds in the periods 1945–1964’Journal of Finance, vol. 23. no. 2, pp. 389–416.
17.
Jun, D., & Malkiel, B.2007, ‘New paradigms in stock market indexing’, European Financial Management, vol. 14, no. 1, 118–26.
18.
Lakonishok, J., Shleifer, A. & Vishny, R. W.1994, ‘Contrarian investment, extrapolation, and risk’, Journal of Finance, vol. 49, no. 5, 1541–78.
19.
Markowitz, H. M.1952, ‘Portfolio Selection’Journal of Finance, vol. 7no. 1, pp. 77–91.
20.
Nomura, 2005, Nomura Asset Management and Research Affiliates to launch products using Fundamental Indexation concept, Press release, Nomura Asset Management Co Limited, available: www.nomura.com, accessed: 12 November, 2007.
21.
Reinganum, M.1981, ‘Misspecification of capital asset pricing: Empirical anomalies based on earnings yield and market values’, Journal of Financial Economica, vol. 9, pp. 9–17.
22.
Ranaldo, A., & Haberle, R.2007. ‘Wolf in sheep's clothing: The active investment strategies behind index performance’, European Financial Management, vol. 14, no. 1, pp. 55–81.
23.
Research Affiliates, 2006, ‘Retrospectives on selected fundamental index™ strategies’, Pasadena, CA, Research Affiliates, LLC.
24.
Roll, R., & Ross, S. A.1994, ‘On the cross-sectional relation between expected returns and betas’, Journal of Finance, vol. XLIX, no. 1, pp. 101–21.
25.
Rosenberg, B., Reid, K. & Lanstein, R.1985, ‘Persuasive evidence of market inefficiency’Journal of Portfolio Management, vol. 11, no. 3 pp. 9–16.
26.
S&P, 2007, ‘S&P Australian indices: Index methodology’, available: www2.standardandpoors.com.
27.
Sharpe, W. F.1964, ‘Capital asset prices: A theory of market equilibrium under conditions of risk’, Journal of Finance, vol. 19, no. 3, 425–42.
28.
Sharpe, W. F.1965, ‘Risk-aversion in the stock market: Some empirical evidence’, Journal of Finance, vol. 20, no. 3, 416–22.
29.
Sharpe, W. F.1966, ‘Mutual fund performance’, Journal of Business, vol. 29, no. 1, 119–38.
