Changing Weights

INDEX FUNDS HAVE, historically, weighted stocks based on their total stock market value. But critics claim this overweights expensive stocks, because a stock’s importance in an index climbs as its share price climbs. One solution: Change the way we weight stocks.

That’s the idea behind fundamental indexing, which was developed by Research Affiliates, a Newport Beach, Calif., money manager headed by Robert Arnott. In 2005, the firm launched its Research Affiliates Fundamental Index, or RAFI, which weights companies by fundamental measures of size, rather than by each company’s market value.

Those fundamental measures of size include sales, cash flow, dividends and book value. By weighting stocks in an index fund using these measures of a company’s fundamental value, the hope is to underweight stocks that are currently overvalued, while overweighting those stocks that are undervalued. This results in portfolios that look similar to those created by fans of factor investing who favor tilts toward value stocks and small-cap shares.

Both Invesco and WisdomTree offer a huge array of stock ETFs that are fundamentally weighted, while Charles Schwab offers six mutual funds and six ETFs that use fundamental weightings. Fundamental weighting is also employed by some bond funds, including Invesco Fundamental High Yield Corporate Bond ETF and Invesco Fundamental Investment Grade Corporate Bond ETF, both exchange-traded funds.

Arguably, the criticism of weighting securities by total market value is more telling when it comes to bonds. How so? If a stock has a high market value, that represents the collective enthusiasm of investors and could be viewed as a positive sign. But if a government or corporation has a substantial amount of debt outstanding, that represents a hefty need for borrowed money. That isn’t a positive sign—and yet these are the issuers with the biggest representation in index funds that weight according to market capitalization.

Next: Asset No. 2: Bonds

Previous: Quality Effect

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