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Fundamental Index Funds/ETF’s – The Basics

After meeting with Preet Banerjee (the blogger behind WhereDoesAllMyMoneyGo) over coffee, I picked up a few tips and some new investment ideas. What really caught my attention during our get together was, not only his fancy suit, but the mention and explanation of fundamental index funds/ETF’s.

What are Fundamental Index Funds/ETF’s?

Fundamental Index Funds/ETF’s are index based investments with a twist. Instead of basing the weighting of the index constituents on a single parameter (the size of market capitalization), a fundamental index is weighted based on multiple fundamental factors.

The theory is that since regular index funds size their positions based on market cap, it’s prone to putting too much weight in over priced stocks (Nortel anyone?) and too little weight in under priced stocks. As a result, a regular index will heavily follow market bubbles and crashes.

The fundamental index, on the other hand, theorizes that it can fix these problems AND outperform the regular index by weighing the index based on fundamental factors of equal weight.

The fundamental factors include:

  1. Dividends – indicates stability
  2. Cash Flow – measures profitability and sustainability
  3. Sales – for growth
  4. Book Value – indicates value

What are the Advantages?

  • It has been proven that index funds outperform the majority of mutual funds. Fundamental index funds have been proven to beat the majority of index funds over the past 50 years. The more inefficient the market, the higher the returns of the fundamental index.
  • Fundamental index funds in efficient markets like Canada and the US have outperformed on average 2%-3% annually over the years. For inefficient emerging markets, fundamental index funds/ETF’s have outperformed 10+%.
  • Less volatility during down turns or market crashes along with higher recovery rate. Basically, better downside protection than a regular index fund (in theory because of the dividend weighting).

What are the Negatives?

  • Fundamental Index ETF’s are more expensive than regular index ETF’s. For example, Claymore’s Canadian fundamental index ETF, CRG, charges a MER of 0.65% compared with a regular Canadian Index ETF, XIU, which charges 0.17%.
  • Even though Claymore explains in their documentation that CRG would statistically beat the index over the long term, it hasn’t been beating the Canadian index ETF XIU since CRG’s inception 2 years ago. As you can see from the chart below, the gold line is CRG and the candlestick chart is XIU. CRG has, for the most part, lagged behind XIU.

  • In CRG’s defense though, the chart is only over the past 2 years as CRG is fairly new. CRG is also heavy in financials (because of the dividend factor) and underweight in materials/energy, the most recent market recovery has left CRG behind.

Where can I buy them?

These ETF’s can be purchased from Claymore (CAD) or Powershares (USD). Here are some of the fundamental index ETF’s that they offer by index and symbol:

Claymore:

  • Canadian Index (S&P/TSX60): CRG (MER: 0.65%)
  • US (S&P500) Index: CLU (MER: 0.65%)
  • International Index (MSCI EAFE): CIE (MER 0.65%)
  • Japanese Index: CJP (MER 0.65%)

Powershares:

  • PowerShares FTSE-RAFI U.S. 1000: PRF (MER 0.60%)
  • PowerShares FTSE-RAFI U.S. Small & Mid 1500: PRFZ (MER 0.60%)
  • PowerShares FTSE-RAFI Dev. Markets ex-US: PXF (MER 0.75%)
  • PowerShares FTSE-RAFI Europe: PEF (MER 0.75%)
  • PowerShares FTSE-RAFI Japan: PJO (MER 0.75%)
  • PowerShares FTSE-RAFI Asia ex-Japan: PAF (MER 0.80%)

Final Thoughts

While it’s all well and good that the statistics for fundamental ETF’s show that they have out performed over the past 5 decades, it is not indicative of future returns. You will have to evaluate yourself whether or not fundamental index ETF’s have a place in your portfolio.

In a future article, I will discuss some of the performance comparisons between the fundamental index and regular index.

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 12 comments… add one }
  • Four Pillars June 2, 2008, 9:39 am

    The problem with a lot of new products is that they exist because of favorable back testing. Will they outperform in the future?

    Your figure for XIU is incorrect – the mer is 0.17% which is pretty good and much cheaper than the Claymore products.

    Mike

  • Jordan June 2, 2008, 9:41 am

    XIU’s MER is actually only 0.17% (check ishares.ca). When comparing 0.65% vs 0.17%, you can see why XIU regularly beats CGR.

    • FT FrugalTrader June 2, 2008, 10:08 am

      Oops, my bad guys. I must have been thinking about the mer of XDV. Fixed.

  • WhereDoesAllMyMoneyGo.com June 2, 2008, 11:08 am

    Thanks for the mention FT – and for the offer of help with the blog migration (I might work on the re-directs over lunch and let ‘er rip tonight – because I’m impatient) :)

    Also, another disadvantage for the fundamental ETF’s are liquidity issues – there are days of thin trading since it’s still early days, so one should be sure to look at volume and perhaps place limit orders.

    I particularly like the downside protection, for example due to fundamental weighting, Nortel represented only about 9% of the Fundamental Canadian Index at the time Nortel represented close to 1/3 of the TSX proper. If you look at the charts during the bubble, you’ll see that the FTSE RAFI index was flat as the TSX tanked. Since the FI’s have a value tilt, they benefit from the flight to quality as money leaves growth and flows to high yielding stocks in turbulent markets.

    It would still be nicer if the costs came down.

    For those looking into FI (fundamental indexing), you need to understand the philosophy behind it, so you can stick to it. For example, Rob Arnott had a great slide that showed that if you invested in the S&P490 instead of the S&P500, you would have earned a few extra percent per year since inception, simply owing to the fact that if you replicate the index, the top x stocks tend to be overvalued and growthy.

    By weighting on market cap alone, you will be placing more weight on stocks that are overvalued, and you will be placing less importance on stocks that are undervalued. FI is based purely on the audited financial statements on four metrics, price is irrelevant.

    There is no shortage of research and analysis on Fundamental Indexing versus plain vanilla indexing. In fact there was a great panel discussion between Jeremy Siegel (FI), Rob Arnott (FI) and Gus Sauter (Vanguard, regular indexing) that can give more insight for those interested.

    http://indexuniverse.com/component/content/article/6/2995.html?Itemid=61

    The debate between FI and regular indexing is intense, so I would recommend really doing some digging into it. You may agree with the philosophy, you may not – but at least you will have a more informed opinion.

  • Michael James June 2, 2008, 11:47 am

    The difference between 0.65% and 0.17% in MER is not slight. It is nearly a factor of 4. The difference of 0.48% per year may seem slight, but it builds up over time. Over 25 years, the two MERs are 15% and 4.2%. This is significant. It will be interesting to see whether the higher-MER Fundamental indexes continue to underperform the regular indexes.

  • Canadian Capitalist June 2, 2008, 11:56 am

    Also underplayed by the FI crowd is how much taxes and extra turnover are incurred. And like Mike points out, the key question is: will the out performance continue? Bogle and Malkiel point out the long history of back-tested strategies that failed to deliver in the future.

    http://www.canadiancapitalist.com/2007/10/22/fundamental-and-traditional-indexing-debate

  • FT FrugalTrader June 2, 2008, 12:06 pm

    Interesting points guys. I think what attracted me to the FI’s is my “chase the performance” voice inside my head. Michael, you are right, the difference in MER is great. I neglected to change my wording after fixing the MER for xiu.

  • WhereDoesAllMyMoneyGo.com June 2, 2008, 3:05 pm

    I think the turnover is historically 10%, as weightings are made once per year (for the index) – but I’ve got a call into RAFI’s affiliate here in Canada and they will provide a more concrete answer.

    I think another point often overlooked is that FI seems to work better in less efficient markets. The backtested outperformance grows with markets that are deemed to be less and less efficient. Some may find plain vanilla indexing to be good for efficient markets and FI for emerging markets (example).

    Of course, this is backtested data and as CC and MJ point out, it may not last. All the more reason to understand what the philosophy is behind FI. Certainly the benefit of hindsight is great for advocating investment strategies, for example the Dogs of the Dow. But as there are proponents of say, value investing and dividend investing, etc. who believe a performance advantage may be gained through active decision making (i.e. undertaking a particular strategy other than plain indexing), they may want to look at FI. You can get your turnkey (pseudo-) active management for almost 2% less than a mutual fund.

    As mentioned before, the premiums on FI and other quant or strategy ETFs are still a bit on the high side, but hopefully they will come down as AUM increases.

  • ThickenMyWallet June 2, 2008, 3:51 pm

    You have to pick your markets carefully with FI. Where you have a larger pool of fundamentally good stocks in the index, there may not be the trade-off between increased fees and performance. Again, context is everything. Switching purely to FI would be a knee-jerk reaction without undertaking some analysis.

    Claymore has some good products but fee creepage in the ETF market is not a positive trend for investors and, with all due respect to Preet, very rarely has a financial company cut fees except under extreme pressure from the public.

  • WhereDoesAllMyMoneyGo.com June 2, 2008, 4:12 pm

    TMW – you are quite right – probably wishful thinking on my part! :)

    The reduction in variable costs associated with the MER’s might reduce the costs by a few measly basis points, but there won’t be a noticeable drop precipitated for altruistic means (on the fixed management fee portion).

    But it’s possible for a new player to come in and undercut the incumbent – the ETF space is exploding (and as we have discussed before, there are advantages and disadvantages to that).

  • Dividend Growth Investor June 4, 2008, 12:53 pm

    I would be hesitant about “passive ways to beat the market”. If you look at the performance of the Equal-Weighted S&P 500 versus the regular, capitalisation weighted S&P 500, you’d see that there are periods when one or the other outperform. I think that reversion to the mean occurs shortly after launching these newly backtested products.. The financial services industry is getting so creative in its quest for taking people’s money..

  • Invest the rest June 10, 2008, 12:04 pm

    DGI – I think you’re looking at this from a “chase the winners” perspective. Rob Arnott and FI’s Canadian distributor (Pro Financial) both point out that FI does not beat the “market” every year, but over the long term it does. I’d rather my money and my client’s be in a product like this than the active manager of the year at +2.5%. Take a look at any bull run of the TSX or S&P 500, how many companies lead the charge?
    In fact, if you take out the top 5-10% of the companies during those times, how does the index perform?
    Lastly, what happens when those top few companies price falls? Cisco, Nortel, et al.

    Granted, the industry is pretty flawed, however, creativity is not always a bad thing.

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