Fundamentally based indexes or fundamental indexes, also called fundamentally weighted indexes, are indexes in which stocks are weighted according to factors related to their fundamentals such as earnings, dividends and assets, commonly used when performing corporate valuations. Indexes that use a composite of several fundamental factors attempt to average out sector biases that may arise from relying on a single fundamental factor. A key belief behind the fundamental index methodology is that underlying corporate accounting/valuation figures are more accurate estimators of a company's intrinsic value, rather than the listed market value of the company, i.e. that one should buy and sell companies in line with their accounting figures rather than according to their current market prices. In this sense fundamental indexing is linked to so-called fundamental analysis.
The fundamental factors commonly used by fundamental index managers are sales, earnings, book value, cash flow and dividends. Even the number of employees have been used in empirical studies on fundamental indexation. Fundamental indices are often contrasted to capitalization-weighted indices. Fundamentally based indices were arguably pioneered by Research Affiliates (RA), which first circulated research on the methodology in mid-2004. However, the method is in practice very similar to the so-called Core Equity Strategy-method launched by Dimensional Fund Advisors (DFA) during the same year. They are similar since DFA evaluates weight of small cap stocks and value stocks in a direct way whereas RA evaluates weight of small cap stocks and value stocks in a more indirect way. Furthermore, fundamental indexation is also seen by some people as merely a practical application and repackaging of the findings of one of the most famous journal articles in modern financial economics: "The Cross-Section of Expected Stock Returns" by Fama & French (1992). This is because the key characteristic of fundamental indices is that they have a combined relative small cap and value stock tilt vs. a capitalization-weighted index, which is for example explicitly shown in a Swedish context by Olof Andersson (2009) in his Thesis "Irrational Indexation". Fundamental indices ride on the small cap and the value stock premiums which have been present in international stock markets during the last 30–40 years so it is not strange that they might beat the market.
Rationale of weighting by fundamentals versus other methods of index weighting
The traditional method of capitalization-weighting indices might by definition imply overweighting overvalued stocks and underweighting undervalued stocks, assuming a price inefficiency. Since investors cannot observe the true fair value of a company, they cannot remove inefficiency altogether but may be able to remove the systematic inefficiency that is arguably inherent in capitalization-weighted indices. Equal-weighting is one method to remove this claimed inefficiency but suffers from high turnover, high volatility, and the requirement to invest potentially large sums in illiquid stocks.
Weighting by fundamental factors avoids the pitfalls of equal weighting while still removing the claimed systematic inefficiency of capitalization weighting. It weights industries by fundamental factors (also called "Main Street" factors ) such as sales, book value, dividends, earnings, or employees. If a stock’s price gets either too high or too low relative to its fair value, weighting by fundamentals will not reflect this bias as far as there is not perfect correlation between stock prices and economic fundamentals. However, the correlation is quite close since the economic fundamentals used are commonly driving the value of a stock. If we assume no correlation in line with Robert Arnott, this arguably prevents fundamentally based indices from participating in bubbles and crashes and thus reduces its volatility while delivering a higher return. However, the strong underperformance of fundamental indices in 2008 when companies such as banks with large fundamentals crashed has shown that it may not prevent it from participating in stock market crashes. When fundamentals change rapidly so may the stock price.
Empirical evidence
If the assumptions of the Capital Asset Pricing Model (CAPM) do not hold then there could be three states of the world in line with the so-called joint hypothesis problem explained by Campbell (1997):