ETFs 2.0 – Fundamental Indexing

Fundamental indices supposedly offer better returns with less risk

Exchange Traded Funds (ETFs) continue to garner investor attention, growing industry assets by more than 16% as of August 31. It is not too difficult to see why investors have embraced ETFs given that they provide investors with a very transparent and cost effective way to access a variety of asset classes.

The first ETF launched was launched in 1989 and was known as the Toronto Participation Fund which was designed to track the TSE 35 Index. Soon after, ETFs made their debut in the U.S. with the launch of the SPDRs which tracked the S&P 500. In 1996, Barclays launched a family of ETFs which today are known as iShares, that were designed to track a number of established market indices.

A common thread of these early ETFs was that they all tracked well known market indices. This certainly made sense, given that these indices were, and to some extent still are, considered to be fairly representative of the equity markets. They are not without their critics. The indices which many ETFs follow are constructed using a methodology that builds the indices according to market capitalization. In other words, bigger companies play a much larger role in the index than smaller companies.

Critics say that this is not the best way to build an index because often times the biggest companies are not necessarily the best companies. In Canada, a perfect example of this was Nortel, which at one point was one of the largest holdings of the index, yet today is bankrupt and long gone. Another point that is often made is that these indices will end up overweighting companies that are overvalued and underweight companies that are undervalued.

To help address these flaws, a process known as fundamental indexation was launched in 2002 by Robert Arnott and his Research Affiliates Fundamental Indexation methodology or RAFI for short. With the RAFI process, indexes are constructed by rating and ranking companies on a number of fundamental factors such as sales, profitability, dividends, book value and number of employees.

The argument is that by measuring these and other factors, we get a much clearer picture of a company’s “economic footprint.” RAFI believes that fundamental indexation can provide a better foundation on which to build an index and should, over time, provide better returns with less volatility than a more traditionally constructed index.

Source: Globefund

Source: Globefund

Whether they actually do that or not remains to be seen. If we look at the performance of the fundamentally constructed ETFs versus their more traditional ETF counterparts, we see that performance has been mixed. In Canada, the fundamental ETFs have outperformed the broader S&P/TSX Composite Index on both an absolute and risk adjusted basis. Given the makeup of the TSX, this is not particularly surprising, with it’s very high sector concentration in energy, financials and materials. In the U.S., the S&P 500 has outpaced the fundamental ETF on both an absolute and risk adjusted basis.

The next thing that we looked at was how the various ETFs performed during the 2008 / 2009 market drop. Again, it was tough to declare a true winner. In Canada, the iShares S&P/TSX Capped Composite dropped by 43% while the iShares Canadian Fundamental Index was off by 41%. In the U.S., the iShares S&P 500 index dropped 49% while the iShares U.S. Fundamental Index was off by 52%.

A final item we looked at was cost. In all cases, the fundamentally constructed index is more costly with an MER in both cases of 0.72%, compared with 0.25% or 0.27% for the more traditional ETFs.

Bottom Line: Fundamental Indexing is based on a very sound theory and there is much evidence and back testing which supports this theory. However, like many sound theories in the investment world, the implementation leaves a bit to be desired. In our preliminary review of the fundamental ETFs that are available in Canada, we did not see significant evidence of the stronger returns and lower risk that is often touted as a benefit of a fundamental ETF. Each ETF should be considered on its own merits. In some cases, a fundamentally constructed index may b e the best choice, while in others, the more traditional ETF is best. In each case, it will depend largely on the investment objectives and risk tolerance of the individual investor.