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Fundamental vs Regular Index Funds/ETF’s

I explained how fundamental index funds work, and how they can outperform regular index funds. But how much do they outperform by? Are they worth the extra MER premium compared to regular index ETF’s? Does the strategy of indexing based on fundamental factors instead of market capitalization really work?

Hopefully, this article will answer some of those questions.

According to pro financial asset management, below are the annualized returns of various indexes between Dec 1984 to Dec 2005:

RankCountryFundamental IndexRegular IndexDifference
9Hong Kong20.15%17.03%3.13%
17United States14.65%12.52%2.13%
22New Zealand6.93%6.77%0.15%

To put it in perspective, if you invested $50,000 20 years ago in a regular Canadian index fund, it would be worth around $361,048 (not counting inflation). Decent right?

However, if you invested the same $50,000 with a Canadian fundamental index fund 20 years ago, it would be worth $639,399 (not counting inflation). This represents a 77% overall difference in account size and a compelling argument for the fundamental indexing strategy.

This also goes to show how much a couple of percentage points can add up over the long term which is also the reason why you want to keep your MER’s as low as possible.

A couple notes about the table above, the returns are the pure index and the not the funds themselves. To appreciate what a fund would return, the MER and tracking error would have to be accounted for. Also past performance does not indicate future returns.

What are your thoughts on the fundamental index funds/ETF’s? Do you own any of them?

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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.

{ 7 comments… add one }
  • FT FrugalTrader June 3, 2008, 9:16 am

    I forgot to mention in the post that, as noted by Preet yesterday, the more inefficient the market, the better the fundamental index performs.

  • Avatar Cash Instinct June 4, 2008, 12:32 am

    Although it would be too much work to research, I wonder about the long-term effects of the costs of rebalancing and/or higher MER, capital gains, etc.

    I also wonder about the 20-year-long study, whether it is a enough long time frame in order to compare «fundamental» Vs «regular».

    Nonetheless, it is an interesting study.

  • Avatar Ed Rempel June 4, 2008, 12:54 am

    Hi FT,

    There is a big danger that fundamental indexing is nothing more than 20:20 hindsight. The way we believe they are mostly created is to go through the data on 100’s of stats and pick a handful that performed best in the past. Then you can show how much better your new index based on those stats would have performed.

    Ken Fisher in his book “The Only 3 Questions you need to ask” claims that fundamental indexes have tended not to outperform ordinary indexes going forward. They only outperform in hindsight.

    Having said that, the 4 factors listed in your first article sound reasonable and I’m sure there must be many stats that would outperform regular indexes.

    My guess would be that these 4 factors would result in more turnover than regular indexes and more turnover almost always results in lower returns.


  • Avatar The Financial Blogger June 4, 2008, 6:53 am

    Were you able to find Funadmental index funds existing over the past 5-10 years and compare it to your chart? I know for a fact that on paper, most trading strategies will present better returns than the market itself. However, when you get to the real world, for some unknown reasons, things end-up a different way ;-)

  • Avatar Dividend Growth Investor June 4, 2008, 12:49 pm

    The fund annual costs are an important yardstick. Sure they did outperform the market for the past 21 years. But was it using real money, or was it a backtest?
    It seems to me that the reason why fundamental indexes outperform the market is because most fundamentally sound companies were unaffected by the bursting of the technology bubble in 2000-2002.


  • Avatar Peter June 5, 2008, 9:45 pm

    Question from a newbie:

    From the perspective of returns, fees, and tax efficiency, how do fundamental index ETFs compare to cap-weighted value index ETFs, e.g. Vanguard VTV, VOE, and VBR?

  • Avatar Invest the rest June 10, 2008, 11:38 am

    DGI – you’ve hit the nail on the head. Fundamentally sounds companies are less affected by bubbles and bursts, and by investing in those companies you can get better risk adjusted returns.
    I know Buffet said he’d prefer a “bumpy 15% over a smooth 10%”, but I don’t think that applies to non-billionaires.
    I’ve looked into FI a lot, and it’s hard to find an arguement against using it as a major position.
    The best part about it, it’s available as a mutual fund, so no worries of low liquidity, etc.

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