Relative to a capitalization weighting, a valuation-based weighting will always be higher for a low-multiple stock, lower for a high-multiple stock and unchanged for a market-multiple stock. Therefore, fundamentals-weighted benchmarks are essentially value-oriented, because they allocate more capital to low price-to-fundamental stocks at the expense of high price-to-fundamental stocks.
The empirical evidence regarding fundamentalsbased indexing shows that low price-to-fundamental stocks tend to generate higher returns than high price-to-fundamental stocks.
In a 2005 study, Rob Arnott and co-authors found that fundamentals-weighted index approaches to the U.S. market outperformed capitalizationweighted passive strategies by 2% per year on average (ignoring transaction costs)over the period from 1962 to 2004 with a comparable level of volatility. A similar study conducted by Nomura Securities over the period from 1988 to August 2005 found that a valuation-weighted approach outperformed by about 3% with slightly less volatility.
At a country level, positive results were also observed for a fundamentals-weighted index based on the Canadian stock market(+3.3%). In fact, the Canadian valuation-weighted index was among the top five highest performers among the 23 countries studied by Nomura Securities.
IMPLICATIONS
For example, when the tech bubble burst in 2000, the underweight of the technology stocks in the Canadian valuation-weighted index resulted in outperformance over its capitalization-weighted counterpart, and by a larger margin than less concentrated benchmarks.
Thus, the more a capitalization-weighted index is concentrated into few sectors, the more room there is for significant valuation tilts on the securities comprising these sectors.
Currently, a large percentage of the Canadian stock market index is composed of energy and financials stocks. Consequently, a correction of oil prices and/or a resurrection of the merger talks in the banking sector could potentially have a significant impact on a Canadian valueoriented portfolio.
As a result, more concentrated markets such as Canada have the potential to create valuationweighted portfolios that are better built to help mitigate the risks present in sectors where a valuation bubble is about to burst.
Valuation-weighted passive investing presents an intriguing alternative to both capitalizationweighted and traditional value benchmarks. It offers many of the benefits of cap-weighting (such as diversification and low costs)but positions investors to benefit from the well-documented value premium phenomenon. Valuationweighting also offers advantages over traditional passive approaches to value investing by incorporating all stocks and responding to changes in valuation dispersion.
A valuation-weighted approach represents a tilt toward low price-to-fundamental stocks and away from high price-to-fundamental stocks. Future performance, therefore, critically depends on the persistence of a value premium. A valuation errors framework suggests investors should expect a longterm value premium to persist in the future. Valuation- weighted passive strategies are a thoughtful way of capturing that premium.
Tony Beaulac is director of global asset allocation with State Street Global Advisors in Montreal. tony_beaulac@ssga.com
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