Fundamentally Weighted Index

What Is a Fundamentally Weighted Index?

A fundamentally weighted index is a type of equity index in which components are chosen based on fundamental criteria as opposed to market capitalization. Fundamentally weighted indexes can base their construction on a range of fundamental metrics, such as revenue, dividend rates, earnings, or book value. Fundamentally weighted indexes provide a benchmark for passively managed funds offered to investors seeking exposure to stocks based on fundamental characteristics.

How Fundamentally Weighted Indexes Work

Fundamentally weighted indexes grew from investor interest in passive management. They became more prevalent in 2004 after research on them was introduced by Research Affiliates. Interest in fundamentally weighted indexes has continued to increase as more fund companies have built customized indexes representing specific investment aspects of the investment market.

Passively managed fundamentally weighted indexes are part of a new wave of tracker fund offerings. Customized tracker funds are passively managed index funds that go beyond mainstream index offerings, seeking to replicate customized indexes constructed based on a wide range of characteristics.

Fundamentally weighted indexes are some of the most prominent customized indexes used by passively managed tracker funds. Fund companies will often create their own customized fundamental index in order to build a replicated portfolio around it for issuance to the public as a structured fund. By using customized fundamentally weighted indexes, investment companies can significantly reduce costs and improve efficacies through lower transaction expenses and annual rebalancing.

Proponents of these indexes claim that they can offer a higher potential return based on aggregate fundamental measures of the market versus market capitalization. Across the industry, they can be constructed using a broad range of fundamental factors that have historically proven to be successful metrics in identifying top-performing investments over time. Typically, investors that tend to prefer fundamentally weighted indexes are more avid investors that are seeking this weighted strategy.

Example of a Fundamentally Weighted Index: FTSE RAFI

The Financial Times Stock Exchange (FTSE) in partnership with Research Affiliates has many fundamentally weighted indexes. Indexes are weighted using fundamental factors such as total cash dividends, free cash flow, total sales, and book equity value.

The Invesco FTSE RAFI U.S. 1000 ETF is one fund managed to a FTSE RAFI Index. The Fund seeks to replicate the holdings and performance of the FTSE RAFI US 1000 Index.

Wisdom Tree Customized Fund Offerings

Wisdom Tree is one fund provider that has taken a lead on offering fundamentally weighted proprietary indexes. The firm’s domestic quality equity ETFs offer investors three passively managed fundamentally weighted index portfolios including WisdomTree U.S. Quality Dividend Growth Fund (DGRW), WisdomTree U.S. Small-Cap Quality Dividend Growth Fund (DGRS), and WisdomTree U.S. Quality Shareholder Yield Fund (QSY).