For example, the total earnings of all stocks in the S&P 500 Index in
2006 were about $735 billion. Google’s earnings came to about $3 billion,
so in an earnings-weighted fundamental index, Google would have a
weight of 0.41 percent. However, because Google has about twice the P-
E ratio of the average firm in the S&P 500 Index, its weight in the market
capitalization-weighted S&P 500 is 0.85 percent, about twice as high.
Since Google does not yet pay any dividends, its weight in a dividend-
weighted fundamental index would be zero.
In a capitalization-weighted index, stocks are never sold no matter
what price they reach. This is because if markets are efficient, the price
represents the fundamental value of the firm and no purchase or sale is
warranted.
However, in a fundamentally weighted index, if a stock price rises
but the fundamental, such as earnings, does not, then shares are sold
until the value of the stock in the index is brought down to the original
levels. The opposite happens when a stock falls for reasons not related to
fundamentals—in this case shares are purchased at the lower price to
bring the stock’s value back to the original levels. Making these sales or
purchases is called rebalancingthe fundamentally weighted portfolio,
and it usually takes place once per year.
One of the advantages of fundamentally weighted portfolios is that
they avoid “bubbles,” those meteoric increases in the prices of stocks
that are not accompanied by increases in dividends, earnings, or other
objective metrics of firm values. This was certainly the case in 1999 and
early 2000 when the technology and Internet stocks jumped to extraor-
dinary valuations based on the hope that their profits would eventually
justify their price. Any fundamentally weighted portfolio would have
sold these stocks as their prices rose, while capitalization-weighted in-
dexes continued to hold them because the efficient market hypothesis
assumes that all price increases are justified.
Note that fundamental indexation does not identify which stocks
are over- or undervalued. It is a “passive” index, and the purchases and
sales of individual stocks are made according to a predetermined for-
mula. Certainly some overpriced stocks will be bought and some under-
priced stocks sold. But it can be shown that if prices are determined by
the noisy market hypothesis, then, on average, a portfolio that buys
stocks that go down more than fundamentals and sells stocks that go up
more than fundamentals will boost returns over a capitalization-
weighted index and reduce risk.^20CHAPTER 20 Fund Performance, Indexing, and Beating the Market 355
(^20) Robert D. Arnott, Jason C. Hsu, and Philip Moore, “Fundamental Indexation,” Financial Analyst
Journalvol. 61, no. 2 (March/April 2005). Also Social Science Research Network (SSRN).