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The Added Value Of Fundamental Indexing

Cris Heaton

[This article originally appeared on our sister site IndexUniverse.eu .]

Conventional investment wisdom holds that investment managers find it far easier to add value in emerging markets than in the developed world. These markets are less mature, with smaller numbers of sophisticated investors, meaning that inefficiencies are larger and last longer. In theory, this should give active fund managers greater opportunities to outperform their benchmark.

In practice, the evidence that active management does better in emerging markets is not convincing. Around three-quarters of US-domiciled emerging equity mutual funds underperformed a capitalisation-weighted emerging market benchmark over the 15 years to December 2011, after adjusting for survivorship bias, according to analysis by Vanguard. The pattern is similar for funds domiciled in Europe.

This less-than-impressive record doesn't mean that there is no value to be had in emerging markets. But there's no reason to think that the same performance issues that hinder active management in general are any smaller in these economies. The career risk of underperforming the market could encourage closet indexing just as easily in emerging markets as in developed ones. Indeed, given the increased volatility of emerging markets, the risk might even be higher.

So, if there are opportunities to exploit, it might be a better bet to use an index-based, non-capitalisation-weighted strategy, such as fundamental indexation, to do so. Lacking some of the behavioural biases that cause active managers to underperform, these indices could be a more reliable way to gain from emerging market inefficiencies.

Impressive Results In Back-Testing

Given that fundamental indexing is a relatively new concept and still far from mainstream even in developed markets, there is a limited track record of actual fund performance to draw upon. However, the back-tested (theoretical) performance of fundamental indexation in emerging markets is certainly eye-catching.

In a 2010 paper, Rob Arnott and Shane Shepherd of Research Affiliates, the promoters of fundamental indexation, showed that the FTSE RAFI Emerging Markets index had outperformed the capitalisation-weighted FTSE Emerging Markets index by a huge nine percentage points per year between 1994 and 2009, without greatly increasing volatility.

This was far in excess of the gains, also based on back-testing, mooted for RAFI's fundamental indexation approach in other markets:there, the claimed outperformance was typically between two and five percentage points a year.

Given that fundamental indices have a strong "value" tilt and studies suggest that the value effect has historically been significant in emerging markets, sizeable outperformance is not surprising. However, nine percentage points of excess return a year looks a remarkable result, raising the question of whether any special factors may have flattered the claimed performance.

Without a detailed performance breakdown, we can't be sure—but it is plausible. For example, while the live FTSE RAFI EM index is now adjusted to reflect the "free float" of index constituents, there was no free-float adjustment in the backtest. Since FTSE and MSCI introduced free-float adjustment for their cap-weighted emerging market indices in 2000, there is a period over which the difference in free-float treatment could have had a significant impact.

Obviously, the impact of this could have added or detracted from performance. But it's worth noting that the back-tested performance of the fundamental index would have given a great deal more weight to some large Chinese and Russian state-owned firms, such as oil firm PetroChina, some of which performed extremely well in the early-to-mid 2000s, even though investors would have had a tough job owning the shares of the companies concerned in the same proportions as their index weightings, given that they only had a small float of tradeable shares.

However, even ignoring this, there are reasons to expect any value added by fundamental indexation in future to be smaller than a backtest might imply. Emerging markets have undoubtedly changed since the 1990s and early 2000s, thanks to greater international interest and an evolving domestic investor base.

This has almost certainly reduced some of their inefficiencies, implying that any premium that can be extracted will be smaller. For this reason, Research Affiliates expects ex-ante outperformance of the index to be more comparable to developed world small caps—closer to the 4 to 5 percent range annually—in the future, says Jason Hsu, the firm's chief investment officer.

Does Cost Matter?

Of course, the risks of data mining mean that you should always be sceptical of back-tests. So, given that fundamental indexing has now been in use for several years, what does the live record say?

There are currently five US-listed fundamentals-based emerging market ETFs—one from PowerShares based on the FTSE RAFI EM index and four from WisdomTree—that have around five years of live history. Other fundamentally weighted emerging market ETFs exist—including listings in China, Hong Kong, India and Korea—but do not have enough history worth reviewing yet.




Fundamental Index Outperformance (per annum)

Tracking Difference:ETF vs. Fundamental Index (p.a.)



PowerShares FTSE RAFI Emerging Markets Portfolio (PXH)

FTSE RAFI Emerging Markets


1.74% (1)




WisdomTree Emerging Markets Equity Income Fund (DEM)

WisdomTree Emerging Markets Equity Income


6.21% (1)




WisdomTree Emerging Markets SmallCap Dividend Fund (DGS)

WisdomTree Emerging Markets SmallCap Dividend


4.9% (2)




WisdomTree India Earnings Fund (EPI)

WisdomTree Emerging Markets SmallCap Dividend


0.42% (3)




WisdomTree Middle East Dividend Fund (GULF)

WisdomTree Middle East Dividend


5.91% (4)




  1. Outperformance versus MSCI Emerging Markets

  2. Outperformance versus MSCI Emerging Markets Small Cap

  3. Outperformance versus MSCI India

  4. Outperformance versus MSCI Arabian Markets ex Saudi Arabia

Sources:PowerShares, WisdomTree, Morningstar. Performance data to 31/12/2012.

As column four shows, all the fundamental indices have outperformed comparable MSCI cap-weighted indices since inception (although some are underperforming on a shorter timeframe). The degree of outperformance is greatest for the WisdomTree ETFs that use purely dividend-based weighting, which perhaps reflects the way that the global search for yield has spread to emerging market equities.

While not enough to draw strong conclusions, these results are encouraging for the idea that fundamental indexing might be a useful tool in emerging markets.

However, they also indicate one potential drawback:the amount of excess return needed to make a fundamentals-based index cost-effective.

While fundamental indices may have lower turnover than other alternative weighting schemes, they will generally have higher turnover than conventional cap-weighted indices. Based on Morningstar data, the Powershares FTSE RAFI Emerging Markets ETF had turnover of 33 percent last year and the WisdomTree Emerging Markets Equity Income ETF had turnover of 37 percent. By comparison, the cap-weighted iShares MSCI Emerging Markets ETF had turnover of 15 percent.

And the ETFs tracking emerging market indices are likely to make heavy use of optimisation—not implementing index changes in full—to reduce turnover. While this means that an ETF may generate lower internal turnover than the index it's following, optimisation also increases the risk of future tracking problems.

However turnover levels are managed, non-cap-weighted index approaches are going to lead to greater implementation costs in emerging markets, causing a noticeable drag on performance. The tracking difference for the emerging market fundamental ETFs—shown in column five in the table—bears this out.

In this column, the actual returns of fundamental emerging market ETFs are compared with the indices they're tracking.

Since inception, the NAVs of these funds have typically underperformed their benchmarks by between one and two percentage points per year. It's clear that implementation costs for non-cap-weighted index trackers can easily wipe out any claimed performance advantage.

For example, the FTSE RAFI Emerging Markets index has outperformed a cap-weighted benchmark (the MSCI Emerging Markets index) by 1.74 percent a year since the inception of Powershares' US-listed FTSE RAFI Emerging Markets ETF (NYSE Arca:PXH) in September 2007. But PXH itself has underperformed the RAFI index by 2.12 percent a year over the same period, more than the notional performance pick-up fundamental indexation was supposed to produce.

By contrast, the iShares MSCI Emerging Markets ETF has underperformed its cap-weighted benchmark by 0.39 percent per year since inception in 2003. The Vanguard FTSE Emerging Markets ETF has underperformed its own benchmark by just 0.2 percent per year since 2005.

And with cap-weighted emerging market ETFs now available at lower costs than before—Vanguard FTSE Emerging Markets and the new iShares Core MSCI Emerging Markets areavailable on TERs of around 0.2 percent a year—fundamental index approaches need to generate even more performance to offset their higher management fees.

While fundamental index approaches in emerging markets continue to claim significant potential added value, investors need to be aware that costs can easily eat away at those extra returns.

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