Fundamental Indexation

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Abstract
A trillion-dollar industry is based on investing in or benchmarking to capitalization-weighted indexes, even though the finance literature rejects the mean–variance efficiency of such indexes. This study investigates whether stock market indexes based on an array of cap-indifferent measures of company size are more mean–variance efficient than those based on market cap. These “Fundamental” indexes were found to deliver consistent, significant benefits relative to standard cap-weighted indexes. The true importance of the difference may have been best noted by Benjamin Graham: In the short run, the market is a voting machine, but in the long run, it is a weighing machine. The insights from the celebrated capital asset pricing model (CAPM) have led many to champion capitalization-weighted equity market portfolios as mean–variance optimal. In response, investment managers and consultants have created a trillion-dollar industry based on investing in passive cap-weighted indexes, such as the S&P 500 Index and other indexes constructed by commercial providers. Trillions more dollars are actively managed and benchmarked against these same cap-weighted indexes, but the CAPM literature already rejects the mean–variance efficiency of cap-weighted equity market indexes. It should be possible, therefore, to construct stock market indexes that are more mean–variance efficient than those based on market capitalization. In pursuing this possibility, we describe a series of equity market indexes weighted by fundamental metrics of size other than market capitalization: book value, trailing five-year average cash flow, trailing five-year average revenues, trailing five-year average sales, ...