Fundamental Indexing Shines in Volatile Markets

If you’re a client of mine, or have ever engaged in a conversation with me about managing investments, then you know I’m a big fan of indexes and low-cost investing. I’m still a fan of the occasional manager who consistently outperforms his/her benchmark but I’m still skeptical that it’s worth the added expense over a long period of time. Today’s post is specifically about fundamental indexing. For those of you out of the loop about fundamental indexing, it’s a strategy which equal-weights the stocks in an index instead of weighting the index holdings based on market capitalization. When you weight based on market cap the way major indexes such as the S&P 500 do, your index inevitably invests the majority of its money in the top holdings. For example, the 20 largest companies in the S&P 500 comprise just over 32% of the index. The other 480 stocks comprise just under 68% of the index. While these market-cap indexes may be more accurately reflecting the economy, they may not be helping your portfolio…


The statistics show that fundamental indexing is working. Not only have equal-weighted indexes dramatically outperformed their market-cap peers over the past year, but the past year has been one of the most volatile and treacherous for investors in recent memory. As of 2/25/2010, the fundamental indexing strategy (as measured by the RAFI US 1000 index) has outperformed the S&P 500 by 20.67%. Over two and five-year periods the returns narrow to slightly less impressive but still respectable 10%.
After reading through various reports comparing the two indexing styles, many have pointed out that fundamental indexing comes with a slightly higher degree of risk, as measured by a standard deviation which is 3.3% greater with the RAFI index. So, you would be experiencing a slightly higher degree of volatility when you chop out some of your largest blue-chip stocks.
What can we draw from this comparison? In my practice, I’ve increased my exposure to unique indexing strategies over the years. I haven’t really embraced the really obscure indexing strategies without proven track records yet, but fundamental indexing has been something which I’ve increased exposure to over the years. I would recommend to investors that they consider diversifying their indexing strategy to include both market-cap and equal-weight exposure.
As for the added cost associated with equal-weight indexes; when you’re talking about a jump from .2% to .58% (S&P 500 vs. RAFI 1000 index) you’re not exactly getting ripped off.
Questions or comments? E-mail me.
Russell Bailyn

Wealth Manager
Premier Financial Advisors, Inc.
14 E 60th Street, #402
New York, NY 10022
P: 212-752-4343 *231
F: 212-752-7673
rbailyn@premieradvisors.net
Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: FINRA/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.
All investing involves risk. One cannot invest directly in an index.

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