Fundamentally weighted indices are worth considering

SHOULD good stock market indices merely reflect the size and breadth of the market, or should they also offer investment value?

In 2005, Robert Arnott, Jason Hsu and Philip Moore challenged the industry convention that indices must be weighted by market capitalisation. Their critique was straightforward but powerful: Capitalisation-weighted indices mechanically allocate more capital to stocks whose prices have already risen the most, regardless of whether those price increases are justified by fundamentals.

Over time, this can result in indices that are systematically biased towards overvalued companies while under-representing firms whose share prices lag despite solid underlying businesses.

As an alternative, the authors proposed weighting indices using fundamental measures such as sales, earnings, cash flow, dividends and book value. Such indices remain rules-based and transparent, but better reflect a company’s financial situation rather than prevailing market sentiment.

Using a sample of the 1,000 largest US companies and weighting them according to their “economic footprint”, Arnott, Hsu and Moore found that between 1962 and 2004, the annualised return of their recalculated index outperformed the S&P 500 by 197 basis points.

Despite this finding, fundamental indexation has not replaced traditional benchmarks. It has however gained some (but not widespread) traction in the US, Europe and parts of Asia, including Japan. Fundamental indices have been adopted by pension funds and long-term asset owners as alternative benchmarks or strategic portfolio allocations.

These indices are attractive precisely because they sit in the space between active and passive investing. They do not rely on discretionary stock selection of active management, yet avoid the self-reinforcing concentration that can arise in cap-weighted indices during market booms.

The structure of Singapore’s equity market makes this issue particularly relevant. The Straits Times Index (STI) is market cap-weighted and therefore heavily influenced by the largest components, namely the three banks, Singtel and property heavyweights.

This means that many profitable, well-run mid-sized companies struggle to gain index representation, analyst coverage and investor attention.

Even though the new iEdge Next 50 indices aim to highlight non-STI companies, they rely on either the traditional market cap approach or on liquidity. Neither constructs the index from the viewpoint of fundamentals.

This issue goes to the heart of the Equity Market Development Programme (EQDP), which aims to revitalise Singapore’s stock market. While the focus has been on incentives, listings and disclosure, index construction itself has received relatively little attention.

Singapore-specific fundamental indices could complement these efforts. By weighting companies according to measures such as earnings or cash flow rather than sheer market size or liquidity, such indices would naturally give greater prominence to firms that are economically significant but not necessarily market heavyweights.

Over time, this could encourage more balanced capital allocation and reduce the concentration risk inherent in traditional benchmarks.

This is not an argument for replacing the STI or abandoning capitalisation-weighted benchmarks, which remain useful reference points.

Admittedly, fundamental indices can be more expensive to maintain than standard trackers, since weights must be adjusted when fundamentals change. However, they remain cheaper than active management. While this higher cost may complicate the launch of an associated exchange-traded fund, it could be a justifiable trade-off to address concentration risks inherent in the Singapore market.

But, as a tool to surface value in the EQDP context, it is certainly worth thinking about.