Blogs & Comment

Bear markets and fundamental indexes

Index investors can choose exchange-traded funds (ETFs) based on market-capitalization weights or ETFs based on fundamental weights (made up of revenues, dividends, cash flow and so on). Id like to highlight, for discussion purposes, some recent differences in relative performance.
Basically, I wonder if the performance differences cast further doubt in addition to uncertainties raised by indexing pioneers John Bogle, Burton Malkiel and William Sharp on the claim that fundamental indexes outperform over the long run.
To briefly review, backtests on stock-market data show fundamental indexes have outperformed cap-weighted indexesover the past two to four decades. One main explanation appears to be that cap-weighted indexes put too much emphasis on overvalued stocks and too little on undervalued stocks; although this means they may perform relatively well during the laterstages of bull markets, they crash harder in bear markets such that they underperform over the full market cycle.
But this script did not play out in the U.S. during the recent bear market. From late 2007 to the end of the first quarter of 2009, the market-cap iShares Russell 1000 Index Fund (IWB) tumbled -55.7% versus -60.7% for the fundamental PowerShares FTSE RAFI U.S. 1000 Fund (PRF). The Rydex S&P Equal Weight ETF (RSP) and SPDR S&P 500 ETF followed a similar pattern — albeit to a lesser extent.
The explanation seems to be that the fundamental ETFs had a noticeably bigger weighting in hard-hit financial stocks. This overweighting should come as no surprise as the fundamentals in the sector were quite strong before the financial crisis arrived.
During the rally after the first quarter of 2009, PRF rose at a faster rate. The explanationseems to be that financial stocksrebounded more vigorously than the market. I do wonder, however, as the economic recovery gains traction (presumably), if thisoutperformance can hold up. One reason is that as the bull market gains momentum, it begins to support cap-weighted ETFs more.
A second reason pertains towhether or not financial stocks can continue to contribute at an above-marketpace to the fundamental index. It could be argued that the fundamentals of the financial sector have become too stretched, and are at risk of leveling off or reversing. For example, the sectors portion of domestic corporate profits has leaped from 16% in the 1970s to over 40% in the 2000s.
As the near meltdown of the financial system highlighted, much of the improvement in the financials fundamentals reflected some questionable and rather unsustainable practices (which could account, in part, for the outperformance found in backtests). Its an open question whether the financial industry will be able to return to those aggressive practices, especially when regulators and lawmakers are now in a more vigilant mood.
Could the main takeaway be that fundamental indexes are not necessarily assured of delivering outperformance in the years ahead? Not only are the arguments provided by Bogle, Malkiel and Sharp a consideration, but just as market caps can go astray for market-cap indexes, fundamental factors may go to extremes for fundamental indexes.
And might this be a country-specific thing? In Canada, Claymore Canadian Fundamental Index ETF (CRQ) experienced a loss of 7.5% over the three years to the end of July, about half the loss on the iShares S&P/TSX Composite Index Fund (XIC). Could Canadas cartel-like banking systembe the moat-protected industry that keeps on delivering?