Fundamentally Indexed or Fundamentally Misconceived: Locating the Source of RAFI Outperformance

Abstract

Fundamental indexing is based on the idea that the conventional approach to indexing, which weights according to capitalization, necessarily puts too much weight on overvalued stocks and not enough on undervalued stocks. Fundamental indexing attempts to correct for these errors by using earnings, dividends, and the like, as weights, instead of capitalization. But a logical alternative to fundamental weighting for removing errors in price is equal weighting. Because of a mistake in the original Arnott publication, equal-weighting has not received its due. This article develops the potential of equal-weighting as an alternative solution to the problems associated with cap-weighted indexes.

TOPICS: Performance measurement, volatility measures, portfolio construction