Book Review > The Fundamental Index

This book is a description of an alternative index to measure share market performance and is the result of several years of research by the authors. It is a fairly technical book, but is relatively easy to read if you have some theoretical understanding of investment markets.

The Fundamental Index ® approach is a straightforward concept that weights companies in an indexed portfolio by their current economic scale, rather than by the market value of their shares. This shifts the frame for investment from one where companies are weighted according to how large the market thinks a company will become in the future (ie based on market capitalisation).

The authors consider that traditional capitalisation-based indexing strategies systematically overweight overpriced securities and underweight underpriced securities. They demonstrate that The Fundamental Index ® outperforms the more traditional indexes such as the S&P 500 at lower risk and with lower cost than most conventional investments.

The book provides a very good discussion in relation to the efficient market hypothesis, concluding that there is considerable empirical evidence to suggest that it is not efficient, simply because price cannot precisely anticipate the unknowable future cash flows of any one company. They use good examples of where the market has erred eg Cisco systems lost $500m in value in only 30 months from March 2000. As a consequence Cisco Systems was grossly overvalued and comprised a much larger part of the relevant indexes than its economic value warranted.

The Fundamental Index ® uses four measures of size which are equally weighted and create a value of economic size. The four measures are: book value, cash flow, sales and dividends. If a company does not pay dividends then the measure is equally weighted between the other three. The relative weight of each company in the index is then a percentage of the total value for all the companies which are to be in the index (eg largest 500).

The authors provide considerable evidence that the strategy will outperform the standard capitalisation-weighted or equally weighted indexes in a variety of situations, including emerging markets and small companies.

They also detail evidence that most of the criticisms of the index are not valid. The primary criticism is that the index obtains its advantage by having a value tilt ie that stocks with low price-book ratios and high dividend yields outperform over long periods. They argue that this simply reflects that fact that capitalisation-weighted indexes fundamentally have a growth bias. Many other criticisms are also discussed.

My view is that market indexes appear to be pretty arbitrary and will effectively be biased one way or another, and anything that gives a method for a better return is probably a good thing. If The Fundamental Index ® was what we were used to as a measure of the market, then we would probably be looking for something better still!

Jenni Eason is a member of the AIA.