The move to fundamental or wealth indices has been welcomed as an important development, as indices provider FTSE announces the launch of a new ‘fundamental index’ series.
“This new thinking is very healthy and we support the idea,” said Roger Urwin, global head of investment consulting at international consultancy Watson Wyatt, in London.
“Wealth-weighted indexed portfolios should compare favourably with cap-weighted. They will have slightly higher costs, but slightly lower risks and higher returns.”
The indices are based on the wealth that the company in the index generates, the consultants say in recent research. “So if Shell generates 10% of all the wealth created by UK companies, then its 7.5% market cap weight is ‘too low’ and if Shell generates only 4% of total wealth, it is ‘too high’.”
Accounting data can be used to develop wealth weights for all UK companies, which has the appeal of relating the size of the exposure to the economic importance of the company.
Fundamental indices for the US and international markets are being developed by FTSE Group, which has teamed up with Rob Arnott of US-based Research Affiliates. Arnott is the creator of Research Affiliates Fundamental Index (RAFI).
Fundamental indexing selects, ranks and weights companies by financial data, such as sales, cash flow, book price and dividends, says FTSE.
“RAFI studies indicate that the fundamental indices have produced consistently higher returns, at modestly lower risk, when compared to cap weighted indices.”
FTSE RAFI 1000 for the US and FTSE RAFI Global ex US 1000 indices are to be launched this autumn, with additional indices being introduced later.