New Paradigms in Stock Market Indexing

Derek Jun and Burton G. Malkiel

European Financial Management, 2008, vol. 14, issue 1, 118-126

Abstract: Considerable recent interest has been shown in a new set of stock‐market indices that are weighted by fundamental factors such as sales, earnings, dividends or book values, rather than by capitalization. In this paper, we analyze the performance of Fundamental Indexing™ (“FI”). First, we show that the source of FI's recent excellent performance is not from its ability to systematically arbitrage mispricing in a noisy market but from increasing the portfolio's exposure to stocks with low price‐to‐book values and with small capitalizations. We find that FI does not produce a positive alpha when its excess returns are explained by the Fama‐French three‐factor model of CAPM beta, the value premium and the size premium. Second, we show that it is possible to construct a portfolio of exchange‐traded funds with similar factor loadings that can replicate, and sometimes, even outperform FI. However, we caution investors not to expect consistent outperformance from portfolios tilted towards value and small‐cap stocks. Historical data shows evidence of mean reversion in the performance of such strategies.

Date: 2008
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