What it means
Most well-known indices are weighted by market capitalisation, which means the largest companies by share price times shares outstanding take up the biggest slices. A fundamentally weighted index changes the ranking system.
Weights are based on what the company actually does, such as the revenue it earns, the profit it makes or the dividends it pays. The argument in favour is that market value weighting automatically puts more money into shares that have recently risen and less into those that have fallen.
If a share becomes overpriced, a market-weighted index holds even more of it. A fundamental index ties weights to business size, so it does not rise or fall in weight just because the price has moved.
Fund managers build these indices by choosing one or several fundamental measures, calculating each company's share of the total, and then rebalancing at set intervals, often once a year. Rebalancing means selling a bit of what has grown and buying a bit of what has shrunk to return to the target weights.
This process creates a built-in tilt toward value-style shares, which are cheaper relative to their fundamentals. For a finance professional, the key point is that the index is a rule, not a forecast.
It will sometimes beat a market-weighted index and sometimes lag it, depending on whether cheaper shares are in favour. It also tends to have higher turnover and, for some measures, a bias toward larger, more mature businesses.
The nuance is that fundamental measures can be distorted by accounting choices, one-off gains and cyclical swings. Many designers blend several measures, for example sales, cash flow, book value and dividends, to avoid relying on a single number that can be manipulated or can fluctuate.
In practice
Real-world examples.
Example
A pension fund wants an equity holding that does not become more concentrated in expensive shares as markets rise. It selects an index weighted by sales and dividends. The fund accepts that returns will differ from the broad market index in the short run.
Example
An asset manager builds an exchange-traded fund that weights companies by a blend of sales, cash flow and book value. At each yearly rebalance the fund sells shares that have run ahead of their fundamentals and buys those that have lagged. Investors pay a slightly higher fee than for a simple market-weighted fund.
Example
A finance student compares two indices over a decade. She finds the fundamentally weighted index lagged during a period when a few very large technology shares led the market, but it held up better after a sharp fall. Her conclusion is that the two approaches simply behave differently in different conditions.
Formula
Calculation
Weight of company i = company i's fundamental measure / total of the fundamental measure for all companies in the index
Suppose an index holds three companies with annual sales of $6,000 million, $3,000 million and $1,000 million. The total sales are 6,000 + 3,000 + 1,000 = $10,000 million. The weights are 6,000 / 10,000 = 60%, 3,000 / 10,000 = 30% and 1,000 / 10,000 = 10%. If their market values are $12,000 million, $30,000 million and $18,000 million, a market-weighted index would instead give weights of 20%, 50% and 30%, because the total market value is $60,000 million.Case study
Seen in the real world.
Sandbar Capital is a fictional investment firm used here as an illustrative example. Its investment committee reviewed a large equity holding that tracked a market-weighted index and noticed that a handful of expensive shares made up nearly half of the portfolio.
The committee tested a fundamentally weighted alternative that used sales, cash flow and dividends in equal parts. On paper, the new index held less of the highest-priced shares and more of the businesses with strong profits relative to their price.
The committee moved half of the holding across and kept the other half in the original index. In this illustrative case, the split lowered the risk of being over-exposed to a few popular shares without staking everything on one method.
Watch out
Common mistakes.
- Assuming a fundamentally weighted index is actively managed, when it follows fixed rules and is rebalanced mechanically.
- Expecting it to beat the market every year, when it can lag whenever expensive growth shares are leading.
- Using a single fundamental measure such as earnings without allowing for one-off gains or losses that distort the figure.
Questions
People also ask.
How is it different from an equal-weighted index?
An equal-weighted index gives every company the same weight, while a fundamental index gives larger businesses larger weights based on their real activity.
Why does it tilt toward value?
Because weights depend on business size rather than price, a share whose price is low relative to its sales or earnings receives a larger weight than a market-weighted index would give it.
Does it cost more to run?
Usually a little, since annual rebalancing creates more trading, and the index providers and fund managers charge for the extra work.
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