The fact that the majority of actively managed funds fail to beat the market consistently is one big reason for the popularity of index investing. Now there is a new method of index investing — fundamental indexation — that claims to reduce some of the risks and volatility inherent in traditional index investing.

Fundamental indexation was developed by Rob Arnott, chairman of Research Affiliates LLC of Pasadena, Calif., and editor of the Financial Analysts Journal. Arnott has teamed up with London-based FTSE Group to create a family of indices in various global markets, all with the moniker FTSE RAFI (research affiliates fundamental index). Fundamental indexing has attracted about US$19 billion since it was introduced two years ago.

Clients can get access to fundamental indexing through a handful of funds offered by Claymore Investments Inc. of Toronto and Pro-Financial Asset Management Inc. of Oakville, Ont.

“Fundamental indexing is evolutionary, if not revolutionary,” says Stuart McKinnon, Pro-Financial’s president. “It’s rules-based, it’s transparent. And backtesting to 1987 has shown an average annual outperformance of about 350 basis points relative to cap-weighted indices in various global markets.”

How does fundamental indexing differ from traditional indexing? Fundamental indexing involves weighting companies in an index according to sales, cash flow, book value and dividends — all measured over five years. This leads to a ranking based on the company’s actual financial situation, not on investor expectations for the future.

Avoiding Bubbles

Companies that make up traditional market indices such as the S&P/TSX composite index are weighted by market capitalization, determined by multiplying the number of outstanding shares by the share price. A market cap-weighted index is, therefore, vulnerable to strong corrections when hot sectors get out of whack or when a popular stock soars so high that it accounts for a disproportionate share of the index — with no underlying support from fundamentals such as assets or profits.

This was the case during the tech boom of 2000; when the bubble imploded, the S&P/TSX composite index suffered a fall of almost 50%.

“Fundamental indexing decreases exposure to highly valued stocks during unsustainable price rises,” says Richard Kang, an independent investment industry consultant in Toronto. “With a traditional index, a stock is going to have more weight as its price rises. This means traditional index investors are putting more money in stocks as they go up, which goes against the wisdom of buying low and selling high. Fundamental indexing is a slight adjustment of the dial for index investors.”

Pro-Financial has the distribution rights to offer a family of open-ended mutual funds in Canada based on the FTSE RAFI indices. It offers five Pro-Index funds: Canadian, U.S., global (excluding U.S.), Hong Kong/China and emerging markets versions.

Claymore has distribution rights for the FTSE RAFI methodology through exchange-traded funds and private pools. Claymore offers four fundamental index funds: Canadian, U.S., international and Japanese versions. The U.S. and Japanese versions are hedged back into Canadian dollars.

More versions are in the works, says Claymore president Som Seif.

The MERs on both the Claymore and Pro-Financial funds are significantly lower than actively managed funds, amounting to 65 basis points annually on no-load versions and rising on the funds and ETFs that compensate advisors with trailer fees.

There are some significant differences in the composition of market-cap weighted indices and fundamental indices. For example, in mid-January, Waterloo, Ont.-based Research in Motion Ltd. accounted for a 4.2% weighting in the S&P/TSX 60, but only 0.6% in the FTSE RAFI Canada index. Potash Corp. of Saskatchewan accounted for 3.9% in the S&P/TSX 60 and only 1.5% of the FTSE RAFI. The top three companies in the S&P/TSX 60 index were Royal Bank of Canada, Manulife Financial Corp., both of Toronto, and RIM; the top three in the FTSE RAFI Canada index were BCE Inc., Royal Bank and Calgary-based Encana Corp. RIM did not even make the FTSE RAFI’s top 10, but placed 43rd on its current list of 55 stocks.

Better In Bear Markets

“After 2000, many pension funds and institutional investors that moved into index investing were hurt badly,” says Seif. “Traditional indexing created a vulnerability to overvalued stocks.

“Markets don’t always get it right,” he adds. “Fundamental indexing is a way to avoid that flaw.”

Both the Claymore and Pro-Financial products have relatively short track records in Canada, and analysts say it’s too soon to assess their performance.

@page_break@One-year performance numbers provided by Claymore for the year ended Dec. 31, 2007, indicate the FTSE RAFI Canada index gained 8.29% during the year, lagging the S&P/TSX 60’s gain of 11.1%. The FTSE RAFI U.S. fundamental index dropped 1.4% (hedged into C$) in 2007, less than the hedged S&P 500 composite’s drop of 10.3%.

Pro-Financial’s McKinnon says fundamental indexing tends to lag regular indices during bubble periods and outperform during bear markets, as occurred in January. Fundamental indexing also shows greater outperformance in less efficient markets, such as those in emerging countries, he says. Backtesting shows that fundamental indexing would have outperformed traditional emerging market indices by about 650 bps a year since 1987. In the more efficient U.S. market, fundamental indexing would have outperformed by about 200 bps, and in Canada by roughly 350 bps.

“Backtesting may not reflect all the realities of execution and trading costs,” warns analyst Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. “But the approach does emphasize value stocks, and there is no shortage of studies that show a strategy of buying undervalued stocks will outperform the market.”

Because of the historical outperformance of fundamental indices over five years, McKinnon recommends the funds for a “core” equity holding, and suggests mixing them with a few funds run by those few managers who have consistently outperformed through active stock-picking. IE