“In the latter stages of a bull market, you’re better off screening based on financial markers,” Davidow says. “They will provide better valuations and discernment going forward than they have in the past.”
Due to the extended bull market, Davidow argues that market-cap indexes are overvalued with a “substantially higher” price-to-earnings ration than fundamental indexes. While markets may be expensive towards the end of a bull market cycle, Davidow argues that there are some securities that are still cheap or fairly priced, and fundamental indexing allows those securities to receive a greater weight than market-cap strategies.
Andy Kapyrin, director of research at Morristown, N.J.-based Regent Atlantic, argues that fundamental strategies can help hedge against overvaluation.
Like market-cap indexes, fundamental indexes change when companies are added and removed through reconstitution, but fundamentals regularly rebalance through a strategic, disciplined approach, selling companies that have appreciated the most and buying others that may have been out of favor, he says.
“Investors tend to over-concentrate in bad investments that have done well recently,” Kapyrin says. ““Fundamental forces investors to rebalance and buy something htat has dropped and sell something that has risen, cutting against a human risk-aversion trait.”
Because this process does not involve the feelings of investors or portfolio managers, it avoids the gambles that active managers occasionally take, but it still represents a higher-risk strategy than market cap strategies.
“Today, with fundamental indexing, they’ll be rebalancing into more energy stocks because they’re cheaper than they used to be and their fundamentals have not changed as much as their prices,” Kapyrin says. “They’ll be selling out of technology like Amazon and Google even though many investors will want to hold onto those stocks. It seems counterintuitive, but fundamentals are always buying things that make folks uncomfortable.”
Davidow likens the mechanism to a blend of passive index strategies and active management.
“In certain environments, active managers can help, especially in playing defense,” Davidow says. “We believe that all of these strategies have a role in the portfolio.”
Fundamental indexing’s excess returns come from both the screening and weighting methodology and the periodic rebalancing of the index, Davidow says. With the proliferation of fundamental index ETFs, including six introduced by Schwab over the past two years, the strategy can now be employed at low cost.