Fundamental indexation: An active value strategy in disguise

Abstract

Arnott et al. (2005) propose a novel investment approach, which they call fundamental indexation. The main idea behind fundamental indexation, or fundamental indexing, is to create an index in which stocks are weighted by economic fundamentals, such as book value, sales and/or earnings, instead of by market capitalisation. An important argument put forward by fundamental indexers is that capitalisation-weighted indices are inferior because they necessarily invest more in overvalued stocks and less in undervalued stocks. This is, however, disputed by, among others, Perold (2007), who argues that capitalisation weighting does not, by itself, create a performance drag. At present, the debate between proponents and critics of fundamental indexing continues to rage on.1.