Accessing Fundamentals: A Differentiated Approach or Just Another Weighting Game?

Stocks give investors an ownership stake in corporate America, but they can also introduce high levels of volatility and uneven growth to a portfolio.

While stocks have been climbing to all-time highs, the reality is that corporate fundamentals have out-paced the return of the broad market. In the past ten years, our analysis has shown the earnings of the S&P 500 companies increased two times the stock price, while dividends increased more than 1.5 times over the stock price.

So how do investors overcome this disconnect and access real corporate fundamentals? The answer is it’s not a simple task. One way is to own individual stocks of companies with strong fundamentals and a history of paying dividends. Even then, stock price remains a very powerful influence on overall value.

We believe investors are embracing the idea of fundamentally-weighted indexes, pioneered by Research Affiliates Chairman and CEO Rob Arnott, as a way to capture greater investment returns. A fundamentally-weighted index operates just as the name implies: individual stocks that make up the index are weighted based on the strength of their underlying fundamentals. The first investable products in this space looked holistically at the fundamentals of a company; while newer products have weighted stocks based on individual fundamental components, such as dividends or earnings.

Regardless of their individual strategies and composition, these products still tend to expose investors to the external factors that influence stock price. If the stocks in the index are down for the day, so is the index – no matter how well the fundamentals are performing.

It’s not clear if investors yet understand that they may not be getting what they pay for with these strategies. Nonetheless, the growth of fundamentally-weighted investing is notable. According to Index Universe, there is approximately $175 billion linked to fundamental ETFs[i]. According to SEC filings, there were more than 100 prospectuses filed with the SEC for new “fundamental” products as of July, 2013.

If these strategies were truly fundamentally based, their performance would act more like that of the fundamentals they claim to represent, rather than the growth of the stock market:

As evidenced in the chart above, the top fundamental ETFs behaved similar to stock price, (SP500), and not like the fundamentals named in their title, such as dividends or earnings.

In order to truly access a company’s fundamentals, what’s needed is a means to remove stock price, and the host of external factors that influence price movement, so that investors can realize the benefits of true corporate fundamentals.

Until now, the means to isolate fundamentals eluded retail investors. But that is soon changing.

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