Fundamentally Weighted
- 01:43
Understand the advantages and disadvantages of fundamentally weighted equity indices
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Transcript
Fundamentally weighted equity indices. Now, fundamentally weighted indices weight based on fundamental metrics, not just price, not just value, but things like sales, earnings, book value, cash flow, and dividend yields, or all of the above. And these metrics are what drive what is known as smart beta strategies and smart beta funds that we see out there in the marketplace. Fundamentally weighted index strategies screen securities in a similar fashion to an active mutual fund manager but it does so in a way that's rule-based and disciplined and it's based upon only the predefined metrics. Now, you won't typically see quotes for these types of indices on TV or in the newspaper, but rather they're used to evaluate and benchmark the various fundamentally weighted investment strategies. Now, the biggest advantage of a fundamentally weighted index is that it could possibly estimate value of a company better than just simply a market cap measurement. In fact, a fundamental weighting leads to what we call a value tilt, given that it uses more metrics to calculate its weightings than simply price and market cap. And that's because fundamentally weighted indices generally have what we call a contrarian effect in that the portfolio weights will shift away from securities that have increased in relative value towards securities that have fallen in relative value whenever the portfolio is rebalanced. Now, the disadvantage is that this methodology requires tons and tons of data. Unlike the other methods where all you needed was price and/or value, you're requiring it a lot more data for all the metrics mentioned.