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By Lawrence carreL
Comparing The Performance Of
Different Fundamental Strategies
In Different Market Environments
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
Fundamental indexing has emerged as one of the most important new investment concepts of the 21st century. The basic
premise is that you can improve the risk-adjusted returns of an index fund by using fundamental metrics (such as the price-to-
earnings ratios or corporate cash ow) to select and/or weight stocks in the index, rather than the traditional metric of market
Proponents of fundamental indexing argue that market-cap-weighted indexes have a basic aw: By denition, they overweight
overvalued stocks and underweight undervalued stocks. Thats because the price of a stock is directly tied to its weight in the
index, so as the price goes up, so does the weight. As a result, shareholders fully participate in market bubbles and in the
bursting of those bubbles.
Researchers have worked to nd new ways of constructing indexes that enhance investors risk-return ratios. These new
fundamental indexes use fundamental factors such as price-to-book value or return on equity instead of market capitaliza-
tion to weight components. By breaking the link between the price of a stock and its weight in an index, fundamental indexes
could in theory deliver better results.
Once you abandon pure market capitalization, however, the question arises of which fundamental metrics to use. While there
is one dominant form of market-cap indexing (free-oat-adjusted market capitalization), you can theoretically use any number
of different metrics to create a fundamentally focused benchmark. And indeed, quite a number of fundamentally focused
indexes have launched over the past few years.
This paper will compare indexes from three of the most well-known fundamentally focused index providersFTSE RAFI, Mar-
ketGrader and WisdomTreeto determine:
How each index is constructed and what it is designed to achieve;
Whether fundamental indexes make good on their promise to outperform the broader markets; and
How different fundamental strategies respond to different market situations.
After all, there is no guarantee that any one method will be superior in all market environments. A sophisticated investor may
want to alternate between different types of fundamental indexes based on how the market is behaving. This paper will at-
tempt to provide a guide for those decisions.
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
A Short History Of Fundamental Indexing . 4
Methodology.......... 5
Do They Beat The Market? Annula and Total Returns 7
Do They Beat The Market? Growth Vs. Value Markets. 11
Do They Beat The Market? Rallying Vs. Declining Markets . 12
Do They Beat The Market? Hi-Vol. Vs. Low-Vol. Markets..... 13
Putting The Indexes To Work In A Portfolio. 14
Conclusion... 16
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
The Theory of Market Capitalization Indexes
Market capitalization has been the dominant form of index-
ing for the past 50 years. Indeed, nearly all index fund assets
currently under management are tied to market-cap-weighted
The theory behind market capitalization indexing starts with
the Efcient Markets Hypothesis, which holds that a stocks
price at any given moment reects all relevant information
that can be known about the stock at that time. If you ac-
cept that premise, predicting a stocks future is impossible,
because all of the factors that will affect its future price are
This has huge ramications for portfolio management, be-
cause it means that essentially all assets should be invested
in a low-cost, broad-based, market-capitalization-weighted
index fund.
Proponents of fundamentally based indexes attack this argu-
ment head-on, rejecting the Efcient Markets Hypothesis
and arguing that price is not the best way to determine a
stocks inherent value. Fundamental indexers argue that inef-
ciency is introduced into the market by speculators, insider
buying and investors tendency to chase returns by pouring
money into rising stocks. These factors cause some stocks to
become overpriced to fair value and other stocks to become
Because market-cap indexes link the weight of a stock to its
price, they put more money into overpriced stocks and less
into underpriced stocksthe exact opposite of what inves-
tors want. Fundamental indexers believe that fundamental
metrics like book value and cash ow provide a purer repre-
sentation of a companys true value, and do not consistently
make weighting errors in one direction.
History of Fundamental Indexing
Although fundamental indexing has gained widespread
prominence only in the past few years, its history traces back
more than a decade. The rst commercial application of a
fundamentally weighted index dates back to the early-1990s,
when Goldman Sachs ran an earnings-weighted index fund
[Siracusano, A Fundamental Challenge, September/October
2007, Journal of Indexes].
Around the same time, MSCI introduced a series of interna-
tional indexes using gross domestic product rather than mar-
ket capitalization to weight stocks. The move was driven by
widespread concerns about a bubble in the Japanese stock
market. Institutional investors who followed that benchmark
wanted to avoid overinvesting in the Japanese bubble, and
MSCI believed that GDP weighting would provide a fairer and
more stable representation of true market value over time.
The eld of fundamental indexing took a big step forward in
2003, when Paul Wood and Richard Evans published a paper
in the Journal of Indexes in which they created an index
called the SandsEnd Prot Based US 100. This index held 100
stocks selected and weighted based on corporate prots.
Using backtested data, the paper claimed that the SandsEnd
Index had beaten the S&P 500 from 1993 to 2002.
That same year, Barclays Global Investors launched the rst
exchange-traded fund based on a fundamentally weighted
index, the dividend-weighted Dow Jones U.S. Select Divi-
dend Index. This index ranked and picked stocks based on
dividends per share. The ETF turned in a strong real-time
performance in 20032005, which attracted many investors
to the space.
Also in 2003, MarketGrader, a fundamental research house,
created its rst fundamental-focused index, the MarketGrad-
er 40. The MarketGrader 40 represented a different approach
to fundamental indexing, using 24 different fundamental
metrics to identify stocks that are positioned well for capital
appreciation. The index does not try to capture broad ex-
posure to the market, but rather acts as a stock-picking
portfolio, creating a focused portfolio of 40 names with the
singular goal of achieving high performance. Although it uses
fundamentals to select and screen stocks, each position in
the index is equal-weighted.
In March 2005, Robert Arnott, the chairman of Research Af-
liates, a small California nancial advisory rm, and two of
his colleaguesJason Hsu, the rms director of research,
and Philip Moore, the vice president of salespublished
a paper in Financial Analysts Journal titled Fundamental
Indexation. This paper attacked the concept of market-cap
weighting with the claim that it overvalues overpriced stocks
and undervalues underpriced stocks. The paper showed that
indexes based on fundamentals could beat the S&P 500 on a
consistent basis.
By the end of that year, PowerShares Capital Management
(now Invesco PowerShares Capital Management), a sponsor
of ETFs, launched a series of ETFs tracking indexes based on
the theory proposed in this paper.
WisdomTree Investments claims that it was working on
creating fundamentally weighted indexes at the same time
as Research Afliates. In June 2006, WisdomTree became
the leading provider of fundamentally weighted indexes and
ETFs, launching 20 ETFs on the New York Stock Exchange in
one day, the largest listing launch in the NYSEs history.

A shOrt histOry OF FuNdAmENtAL iNdExiNg
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
This paper compares the returns of three sets of fundamen-
tal indexes against the returns of a market-cap-weighted
benchmark. It also looks at how the different fundamental
strategies compare with one another during different market
For simplicitys sake, the paper focuses on large-cap U.S.
equities, the most liquid and widely held asset class among
U.S. investors.
The Indexes
The S&P 500 serves as the market-cap-weighted benchmark
index for this study. The S&P 500 was chosen because it is
one of the best established market capitalization indexes in
the world. It holds 500 U.S.-domiciled companies selected by
the S&P Index Committee as leading companies in the U.S.
economy. Stocks must have a market capitalization of at least
$5 billion to qualify for the index. Components represent ap-
proximately 70% of the U.S. equities market.
Wisdom Tree LargeCap Dividend Index
Among the fundamentally focused indexes, WisdomTree
uses the simplest methodology to create its indexes. Its
primary index family uses cash dividends as the only metric
to determine both the inclusion and weighting of a stock
within the index; other indexes offered by WisdomTree use
earnings as the sole metric to select and weight stocks.
WisdomTree considers these the two most effective metrics
of scal tness. Wharton professor and WisdomTree senior
strategy advisor Jeremy Siegel sums up the rationale behind
the WisdomTree indexes when he says that, From 1926
through 2006, reinvestment of dividends accounted for 96%
of the stock markets total return after ination. In addition,
weighting by dividends can raise a portfolios dividend yield.
Research shows that portfolios comprised of the highest
dividend-yielding stocks within the S&P 500 Index have his-
torically outperformed the S&P 500 Index as a whole.
Obviously, a company must pay a regular cash dividend to be
eligible for inclusion in a WisdomTree dividend index. Among
the other criteria, the company must have at least $100 mil-
lion in market capitalization. It must issue common shares or
shares in a real estate investment trust. Additionally, it must
list on a major stock exchange and meet minimum trading
volume standards.
The WisdomTree LargeCap Dividend Index holds the 300
largest dividend-paying stocks in the U.S. market. It is
reweighted annually to reect the proportionate share of
the aggregate cash dividends each component company is
projected to pay in the coming year.
The fundamentally weighted FTSE RAFI US 1000 Index holds
1,000 equities. Securities are selected and weighted based
on a blend of four metrics: book value, income, sales and divi-
dends. It is reweighted and recongured on an annual basis.
Those with the highest fundamental score, or strength, are
added to the index, which is reweighted and recongured
on an annual basis. Of the four metrics, RAFI says sales are
the most signicant, since prots, book value and dividends
ow from sales. RAFI says sales are more powerful than
dividends. While using sales as a metric works best in a bull
market, it creates more volatility. Dividends, on the other
hand, have lower volatility, causing them to perform better
in bear markets. By using them both, RAFI hopes to get the
best of both worlds.
MarketGrader Large Cap
MarketGrader builds indexes based on four core principles:

Select companies strictly on comprehensive fundamen-
tal analysis;
Provide proper diversication by limiting exposure to any
given sector;
Detach portfolio maintenance from human bias and emo-
tion by using a disciplined rebalancing strategy; and
Equal-weight components within the index.
The MarketGrader indexes are focused indexes. The Mar-
ketGrader Large Cap Index, for instance, holds just 100
components. That compares with 500 stocks in the S&P 500,
300 stocks in the WisdomTree LargeCap Dividend Index and
1,000 stocks in the FTSE RAFI 1000.
MarketGrader also rebalances its indexes more frequently
than competing indexes, following either a quarterly or
semiannual rebalancing schedule, compared with an annual
rebalancing schedule for FTSE RAFI and WisdomTree.
The MarketGrader indexes are also equally weighted. The
Large Cap Index, for instance, starts with a 1% allocation
at each rebalance. By contrast, an index like the S&P 500
typically has only 2030 components weighted 1% or higher,
with much smaller allocations to the vast majority of compo-
These featuresa focused portfolio, regular rebalancing
schedule and equal weighting of componentshave led
some to refer to the MarketGrader indexes as stock-pickers
indexes. That is, they make very specic bets on individual
companies and sectors based on the latest fundamental data
available in the marketplace.
To create the MarketGrader Large Cap Index, MarketGrader
examines 5,700 U.S.-listed companies using 24 fundamental
factors in four key areasgrowth, value, protability and cash
ow. Each company gets a grade based on its fundamental
strength, and the top-graded large-cap companies earn a
place in the index, subject to index rules designed to ensure
liquidity and sector diversication. Importantly, although the
selection is based on fundamentals, individual components
are equal-weighted within the index.
Time Period
This study evaluates these indexes from the beginning of the
last bull market through the present time. This period runs
from Jan. 1, 2003 to June 30, 2008. The start date was cho-
sen as the rst full year of the most recent bull market. The
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
end date reects the last date for which data was available as
of the writing of this paper.
Each of the fundamental indexes was launched during this
period, so the returns reect both backtested and real-time
results. S&P 500 returns are all real-time returns.
This paper will examine the performance of these strategies
in the following situations:
Total and annual returns
Returns during growth/value markets
Returns during rallies and declines
Returns during periods of high and low volatility
Returns as part of a simple, well-diversied market
Volatility of returns

Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
Fundamental indexes are designed to generate superior re-
turns compared with market-cap-weighted indexes. Over the
past ve and a half years, however, the results are mixed.
The best-performing of the three indexes over the period ex-
amined was the MarketGrader Large Cap Index. From 2003
through the second quarter of 2008, the MarketGrader index
delivered a total return of 146.34%, nearly tripling the return
of the competing fundamentally weighted indexes and more
than doubling the return of the benchmark S&P 500.
By contrast, the market-cap-weighted S&P 500, which
posted a 61.08% return, actually beat both the fundamentally
weighted FTSE RAFI US 1000 Index and the dividend-weight-
ed WisdomTree LargeCap Dividend Index, which returned
53.45% and 52.04%, respectively (see Figure 1).
In the early years of the bull market2003 and 2004the
fundamental indexes mostly outperformed the market-cap-
weighted S&P 500. Part of this can be attributed to the inher-
ent bias in the weightings. Because it is weighted according
to price, the S&P 500 has an inherent bias toward large-cap
and growth stocks. Meanwhile, fundamentally weighted in-
dexes have a relative bias toward small-cap and value stocks.
Small-cap stocks typically outperform large-cap stocks at the
beginning of a bull market, and value stocks increase at a
faster rate than growth stocks. The reason, at least in theory,
is that value stocks and small-caps are more exposed to the
vagaries of economic growthmore threatened by economic
downturns, and more buoyed by economic growth. As a
result, they respond rst and fastest to changing economic
At the end of the bull markets rst full year2003the
FTSE RAFI and MarketGrader indexes posted returns of
31.08% and 37.15%, respectively, beating the S&P 500s
return of 28.68%. The dividend-weighted WisdomTree index,
however, underperformed, with a return of just 25.17%.
This may have been driven by WisdomTrees dividend-only
policy, which essentially excluded the Technology sector from
consideration; Technology played a role in the 2003 rebound
(see Figure 2).
By 2004, the bull market was rolling along, and so were all
the fundamental benchmarks.
In 2004, all three fundamental indexes beat the S&P 500 by
at least 1.3 percentage points. The MarketGrader Large Cap
100 exceeded the S&P 500 by eight percentage points, as its
focused portfolio of just 100 names outperformed its more
diversied competitors (see Figure 3).
In 2005, as the market weakened, the results turned decid-
edly mixed. The S&P 500 rose 4.91% for the year, compared
with the WisdomTree and FTSE RAFI indexes, which returned
4.60% and 3.82%, respectively. By contrast, the MarketGrad-
er index continued its strong performance, delivering 17.72%
returns for the year (see Figure 4).
Figure 2: Performance For 2003
Figure 3: Performance For 2004
dO thEy bEAt thE mArkEt? ANNuAL ANd tOtAL rEturNs
Figure 1: Total Percentage Return of S&P Vs.
Fundamental Indexes: 20032008
A year-by-year analysis shows where the FTSE RAFI and WisdomTree
indexes fell behind and where the MarketGrader index pulled ahead.
S&P 500 (Total Return) : (61.08)
03 04 05 06 07 08
WisdomTree Large Cap US Dividend Index
FTSE RAFI U.S. 1000 index (53.45)
MarketGrader Large Cap 100 Index (146.43)
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
In 2006, everything switched. WisdomTrees index posted the
best return, at 20.04%, and FTSE RAFI earned 17.13%. Both
topped the 15.79% returned by the market-cap index.
The MarketGrader index, however, fared the worst, falling
3.5 percentage points behind the S&P 500 with a return of
12.28% (see Figure 5). It was the MarketGraders worst full-
year performance during the entire study and the only year
the S&P 500 beat the MarketGrader index.
Both the WisdomTree and FTSE RAFI indexes posted robust
performances, 2006 was a strong year for high-yielding
stocks, as REITs, Financials and Utilities all turned in solid
The MarketGrader indexes suffered from poor relative perfor-
mance by the Energy sector compared to the high-yielding
sectors of the economy. The MarketGrader indexes were
heavily weighted in Energy at the time.
2007 was a difcult year for the stock market. The market
reached new all-time highs on the Dow Jones Industrial Aver-
age and the S&P 500, but also experienced a signicant down-
turn, which later turned into the bear market of 2008. Over the
year, however, the S&P 500 closed the year up 5.49%.
Two fundamentally weighted indexes both under-performed
the market-cap index: WisdomTree earned 2.94%, while
FTSE RAFI gained 1.66%. These results are not out of line
with the general characteristics of fundamentally weighted
indexes. In 2007, large-cap and growth stocks led the market,
while small-caps and value stocks lagged.
Interestingly, however, the MarketGrader Large Cap Index
posted its best year since 2003, when the bull market began.
Its return of 20.46% was four times greater than the S&P
500 and many multiples greater than the fundamentally
weighted indexes (see Figure 6). Its strong performance in a
year in which other fundamentally focused indexes suffered
suggests that it captured a fundamentally different segment
of the investment universe than its peers.
The most surprising factor in our examination of fundamental
performance was how poorly the indexes performed in the
rst half of 2008, when the market was undeniably bearish.
Rob Arnott, one of the developers of the FTSE RAFI index,
notes that his indexes tend to have the largest amount of
outperformance during bear markets. From 1962 to 2007, the
RAFI U.S. Large (a precursor of the FTSE RAFI 1000 Index)
outperformed the S&P 500 by 0.7% during bull markets; dur-
ing bear markets, that margin of outperformance was 5.8%
[The Fundamental Index, Rob Arnott, Jason Hsu and John
West, 2008, p. 101.]
Evidence in the rst half of 2008 suggests otherwise.
During the rst six months of 2008, the S&P 500 fell 11.91%.
Meanwhile, the FTSE RAFI index fell 15.62% and the Wis-
domTree index lost 16.25%. Once again, MarketGrader was
the best of the group. While the index still posted a loss, at
5.12%, it was less than half the size of the loss on the S&P
500 (see Figure 7).
The most likely explanation for the poor performance of the
FTSE RAFI and WisdomTree indexes is the high weight they
give to nancial stocks. Fundamentally weighted indexes
typically overweight Financials due to their high sales and
high dividend yields. Meanwhile, much like 2006, the Mar-
ketGrader Large Cap Index was overweighted to the Energy
sector and underweight Financials relative to the S&P 500.
Figure 4: Performance For 2005
Figure 5: Performance For 2006
Figure 6: Performance For 2007
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
During this six-month period, the price of oil surged 52% to
$145, while the Financials sector plunged into crisis because
of the bad investments on their books. With the credit crunch
hurting the Financials sector in the rst half of 2008, any
index overweight Financials suffered. MarketGrader managed
to avoid some of this downturn.
Performance Review
It is surprising (and indeed contradicts some of the literature)
to nd that the two fundamentally weighted indexes have ac-
tually under-performed the benchmark S&P 500 since 2003.
Part of this has to do with the recent under-performance of
Financials stocks, but that cannot fully explain the perfor-
mance. After all, the WisdomTree index lost to the S&P 500
in three of the ve full-year periods (as well as in the rst half
of 2008), and the FTSE RAFI index lost in two.
The only index to show real outperformance was the Market-
Grader index, which not only beat the S&P 500 on a total-
return basis but also in each one-year period except 2006.
How did it achieve this outperformance? On a sector basis, the
MarketGrader index often invests in a different market prole
than the benchmark indexes. With its semiannual rebalanc-
ing schedule and focused portfolio of 100 names, it can take
concentrated sector bets, often placing 25% of the portfolio in a
single part of the marketcompared with a maximum weight of
approximately 15%20% in the benchmark S&P 500 (and similar
levels in the other fundamental benchmarks). That allows the
MarketGrader index to capitalize on strong growth in certain sec-
tors, as it did with the Energy bull market of 20062007.
In addition, because it is equally weighted, the MarketGrader
index tends to have a lower market capitalization than the
competing indexes.
Finally, the MarketGrader index makes focused single-stock
bets: With just 100 stocks, equally weighted, it starts each
rebalance with a 1% allocation to each position. By contrast,
the FTSE RAFI index holds 1,000 stocks with an average al-
location of just 0.10%. In fact, as of September 3, 2008, only
17 of the 1,000 stocks in the FTSE RAFI US 1000 Index had
weights of 1% or higher. If the MarketGrader index selects
the right stocks, it will be rewarded.
Measuring Risk
The ip side of return, of course, is risk. The standard way of
measuring risk is to look at standard deviation, or the histori-
cal volatility of returns over a given time frame; the lower the
standard deviation, the lower the risk.
Over the time period studied, the MarketGrader index had
the lowest annual standard deviation of the four indexes, at
9.38, which was remarkable considering the index also had
the single strongest total performance.
Looking at annual standard deviation, the WisdomTree index
was second at 9.62, followed by the S&P 500 at 9.75 and the
FTSE RAFI at 11.80 (see Figure 8).
You can also look at standard deviation over different time
frames. Figure 9 compares one-day, one-month, quarterly
and annual standard deviations of the various portfolios. As
shown, the MarketGrader index had the highest daily and
monthly standard deviations, suggesting that it has the high-
est short-term volatility. Its position improves as you move to
quarterly and annual returns (see Figure 9).
In contrast, the FTSE RAFI and WisdomTree indexes have
lower short-term volatility, but higher long-term volatility.
One nal way to consider the risk of a portfolio is to look at
how each index performed during periods of market stress.
To do this, we examined the worst one-month performance
of each index.
Interestingly, the S&P 500 had the smallest worst month
performance, with an 8.4% pullback in June 2008. The FTSE
RAFI and WisdomTree indexes also saw their worst one-
month decline in June 2008, falling 10.9% each. By contrast,
MarketGraders Large Cap 100 saw its worst month in Janu-
ary 2008, when it fell -9.2%.
Figure 7: Performance For 2008
Total Return (2003 -
Q2 08)
Standard Deviation Of
Annual Returns 2003 2004 2005 2006 2007 1H 2008
S&P 500 61.08% 9.75 28.68 10.88 4.91 15.79 5.49 -11.91
FTSE RAFI 53.45% 11.80 31.08 12.23 3.82 17.13 1.66 -15.62
MarketGrader 146.34% 9.38 37.15 18.89 17.72 12.28 20.46 -5.12
WisdomTree 52.04% 9.62 25.17 12.21 4.60 20.04 2.94 -16.25
Figure 8: Annual Index Return and Standard Deviation: 2003-1H 2008
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
S&P 500 (Total
1000 Index
MarketGrader Large
Cap 100 Index
LargeCap US
Dividend Index
Daily 0.89 0.89 1.04 0.86
Monthly 2.87 3.19 3.62 2.87
Quarterly 5.56 6.55 5.76 6.00
Annual 9.75 11.80 9.38 9.62
Figure 9: Standard Deviation Of Daily, Monthly And Yearly
Returns: 20031H 2008
Best Month Worst Month
Index % Change Month % Change Month
S&P 500 (Total
8.2 4/30/03 -8.4 6/30/08
9.9 4/30/03 -10.9 6/30/08
Figure 10: Best and Worst Monthly Returns: 20031H
The MarketGrader index produced the highest annual returns
without a clear corresponding increase in risk over the time
period studied. While it did show higher short-term volatility
a result, likely, of its concentrated portfolioit showed lower
long-term volatility and had a smaller worst month draw-
down than either the FTSE RAFI or WisdomTree indexes.
The FTSE RAFI index had the highest annual standard devia-
tion of any of the four indexes studied, and this added volatil-
ity was not compensated for by added returns.
The WisdomTree and FTSE RAFI indexes were hurt by the
summer swoon in nancial stocks; both indexes are heavily
invested in the Financials sector. The MarketGrader index ap-
peared to dodge that problem, helping its long-term returns
and long-term risk measures.
It is too early to close the book on these volatility studies.
While 20031H 2008 is a substantial time frame, it covers a
broadly rising market. How these funds will react to a sub-
stantial bear market remains to be seen.
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
dO thEy bEAt thE mArkEt? grOwth Vs. VALuE mArkEts
Indexes with fundamental weightings tend to have a relative
bias toward small-cap and value stocks, while market-cap-
weighted indexes have an inherent bias toward large-cap and
growth stocks.
Critics of fundamentally weighted indexes say that the strong
historical returns claimed by the fundamental indexes are
really just a reection of recent strong performance during
value markets. Meanwhile, fundamental index proponents
concede that market-cap indexes may outperform fundamen-
tal indexes during certain growth markets.
We decided to examine how each of the three indexes per-
formed during times when growth stocks were in vogue and
during periods of value stock outperformance, to see if inves-
tors might benet from shifting from one index to another
during different market movements.
We divided our study period into growth and value seg-
ments. We dened a growth market as any period in which
the S&P/Citi Growth Index steadily outperformed the S&P/
Citi Value Index, and a value market as the reverse.
Figure 11 shows the time periods of value and growth mar-
kets from Jan. 1, 2003 to June 30, 2008. The graph shows
clearly that most of the period from Jan. 1, 2003 to Dec. 31,
2006 was a value market, while most of 2007 and 2008 can
be characterized as a growth market.
With data beginning Jan. 1, 2003, the rst growth market ran 65
days, to March 12, 2003. The rst value market rallied for the next
373 days, ending March 19, 2004. The next short-lived growth
market lasted just 52 days, ending May 10. The second value
market takes up the majority of the time period1,102 daysend-
ing May 17, 2007. The largest growth market then begins, running
231 days, until Jan. 3, 2008. The nal value market lasted only
29 days, until Feb. 1, and the nal growth market ends after 165
days, on July 15, 2008 (see Figure 12).

The data prove the value bias in fundamental strategies. Over
the ve-and-a-half year period, the MarketGrader Large Cap
100 Index posted the best average return in a value market,
at 40.54%. The FTSE RAFI US 1000 jumped 32.56% and the
WisdomTree LargeCap Dividend Index climbed 30.88%. All
the fundamental indexes outperformed the S&P 500s gain of
28.06% (see Figure 12).
However, the growth market showed some surprising
results. During the growth markets, all the indexes (including
the S&P 500) posted negative results for their average total
returns. In fact, the MarketGrader index was the only index
to post a positive return during a growth market, doing so in
two of the four growth markets studied.
The S&P 500s average loss during the growth market,
-6.39%, was smaller than the WisdomTree Large Caps
-9.26% and the FTSE RAFI 1000s -9.79% loss. The Market-
Grader LargeCap posted the smallest average loss, at just
-1.25% (see Figure 13).
Overall, the results are consistent with the lay understanding
of fundamental indexes: They perform well in value markets
and less well in growth markets. However, the MarketGrader
index appears to have adapted better to growth environ-
ments, outperforming its benchmark during positive periods
for growth as well as strong periods for value.
Figure 12: Average Performance During Value Markets
Figure 13: Average Performance During Growth Markets
Start End Market
(Days) S&P 500
1/6/03 3/12/03 Growth 65 -13.08 -16.22 -10.03 -14.33
3/12/03 3/19/04 Value 373 40.45 48.81 48.60 39.00
3/19/04 5/10/04 Growth 52 -1.87 -3.38 -3.16 -2.18
5/10/04 5/17/07 Value 1,102 47.20 50.76 79.36 53.74
5/17/07 1/3/08 Growth 231 -3.19 -7.02 5.85 -5.59
1/3/08 2/1/08 Value 29 -3.47 -1.89 -6.33 -0.10
2/1/08 7/15/08 Growth 165 -7.43 -12.53 2.33 -14.93
-6.39 -9.79 -1.25 -9.26
28.06 32.56 40.54 30.88
Figure 14: Growth vs. Value
Figure 11: Growth Vs. Value 2003-2008
A growth market is shown by a rising red line, while value markets
are shown in blue.
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
As mentioned earlier, the developers of FTSE RAFI state
that their fundamental indexes achieve their highest outper-
formance during bear markets. With price the main factor in
market-cap indexes, they can suffer serious losses when the
stock market falls into a signicant decline, as former market
darlings are laid low. The most striking example of this came
during the wake of the technology bubble of the late 1990s.
According to the Arnott et al. paper, Fundamental Index-
ation, which set forth the formula for the FTSE RAFI 1000,
in a true bear marketsignied by a 20% decline from a
recent highthe FTSE RAFI indexes outperformed market-
cap indexes by an average of 640 basis points a year. In a
bull market, dened by a 20% rally, the FTSE RAFI indexes
outperformed the market-cap indexes by an average of just
55 basis points per year.

Because full-blown bull and bear markets occur infrequently,
we decided to look at smaller up and down moves to under-
stand how these indexes react to rallies and declines. Spe-
cically, we dened a signicant move to be a 5% move in
either direction. Over the ve-and-a-half-year period studied,
the S&P 500 experienced 14 distinct rallies and declines of
5% or more. One lasted as long as 317 days, which saw the
S&P 500 rise 38.61%; and others were as short as 10 days.
Over the 20032008 period, the S&P 500 posted an average
return of 12.92% during the rallies and an average loss of
8.10% during the declines.
During the rallying markets, MarketGrader once again posted
the best returns, with an average gain of 16.54%. The FTSE
RAFI 1000 came in at 13.37%, beating the market by 45
basis points (0.45%). However, WisdomTree again failed to
top the market-cap index, posting an average return 71 basis
points below the S&P 500 (see Figure 15).
This result is not surprising considering WisdomTrees funda-
mental weighting is based on dividends. Dividend-focused
indexes are noticeably light on high-beta sectors like Tech-
nology and Biotechnology, which tend to experience large
moves during up markets. Mature companies may have less
risk, but also fewer growth prospects.
During the declines, the opposite result occurred. The FTSE
RAFI index failed to beat the market, turning in the worst per-
formance among the four indexes and losing to the S&P 500
by an average of 58 basis points (0.58%). The MarketGrader
index posted an average loss of 8.08%, nearly identical to
the S&P 500s loss of 8.10%. Meanwhile, the WisdomTree
indexs tilt toward established companies appeared to help
it perform well, as it posted the smallest average loss during
periods of decline, just 7.87%, or 23 basis points better than
the S&P 500 (see Figure 16).
dO thEy bEAt thE mArkEt? rALLyiNg Vs. dEcLiNiNg mArkEts
Figure 15: Average Performance During Rallying Markets
Figure 16: Average Performance During Declining Markets
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
dO thEy bEAt thE mArkEt? hi-VOL. Vs. LOw-VOL. mArkEts
The nal factor studied was how well the indexes perform in
periods of high volatility and low volatility. The premier index
for measuring volatility is the Chicago Board Options Ex-
change Volatility Index, better known by its ticker symbol, VIX.
Using index options, the VIX measures the markets expecta-
tion of volatility over the next 30 days. Values above 20 signify
high volatility, while values below 20 signify less-volatile
times, when investors are more complacent.
Over the ve-and-a-half year time frame, the VIX experienced
high, but falling, volatility during the period from Jan. 1, 2003
to Jan. 9, 2004. The period between then and July 24, 2007
was one of low volatility for the market. Over the past year,
volatility again became a force in the market.
During all three periods, the MarketGrader index outper-
formed its peers. For the rst period of high volatility, it
posted an average return of 38.25%. The FTSE RAFI came in
second, posting a return of 32.33%. Due to its bias toward
mature companies, WisdomTree posted the lowest results,
with an average of 25.41%. This failed to surpass even the
29.89% posted by the S&P 500 (see Figure 18).
During the period of low volatility, the MarketGrader index
again far exceeded the rest of the market, posting an 81.71%
gain; WisdomTree and FTSE RAFI both exceeded the S&P
500, with average gains of 49.37% and 44.28%, respectively.
The S&P 500 gained 43.58%.
During the second period of high volatilitywhich includes
the recent bear market MarketGrader outperformed its
peers, with a loss of just 1.94%. The S&P 500 posted a loss
of 13.63%. Both of the fundamentally weighted indexes
underperformed the market-cap index: WisdomTree lost
18.84%, while FTSE RAFI fell 19.63% (see Figure 18).
There are not enough periods of study to draw any reason-
able conclusions about the long-term performance during
these different market environments, although the results are
interesting to consider nonetheless.
Figure 18: Performance In High And Low Volatility Markets
Start End Period Duration (Days) S&P 500 FTSE RAFI MarketGrader WisdomTree
1/1/03 1/9/2004 High Volatility (Falling) 374 29.89 32.33 38.25 25.41
1/9/2004 7/24/2007 Low Volatility 1,292 43.58 44.28 81.71 49.37
7/24/2007 6/30/2008 High Volatility (Rising) 342 -13.63 -19.63 -1.94 -18.84
Figure 17: High and Low Volatility Periods
12/02 12/03
Low Volatility
High Volatility
12/04 12/05 12/06 12/07
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
PuttiNg thE iNdExEs tO wOrk iN A POrtFOLiO
Real investors looking to allocate to fundamental indexes
likely will buy index funds as part of a broader asset allocation
To see how these three indexes would have performed inside
a portfolio, we created a simple diversied portfolio compris-
ing 50% domestic equities, 30% international equities and
20% domestic bonds. The international equities position was
represented by the MSCI EAFE Index, the domestic bonds
allocation was represented by the Lehman Brothers U.S.
Aggregate Bond Index and the domestic equities position
was allocated to indexes tracking the four domestic large-cap
equity indexes studied.
It is important to note that indexes are not investable. Invest-
able products based on the fundamental indexes did not
exist over the full time period studied. Had they existed, they
would have charged annual management fees. In addition,
there may have been fees or commissions to enter, exit and
rebalance the funds.
As one would expect, the portfolios performed in line with
the total returns of the indexes. The sample portfolio hold-
ing the MarketGrader Large Cap Index delivered the highest
cumulative returns, 121.43%, over the ve-and-a-half-year
study period. The portfolio containing the S&P 500 climbed
78.80%, while the fundamentally weighted indexes lagged.
The FTSE RAFI portfolio gained 74.99% and WisdomTree
posted only 74.28% cumulative returns (see Figure 19).
The MarketGrader portfolio outperformed both during (some)
growth and (all) value markets. The WisdomTree and FTSE
RAFI portfolios again beat the S&P 500 in a value market, but
posted larger losses in the average growth market.
In terms of the 5% rallies and declines, the MarketGrader
posted the best results during rallies, 14.04%. The FTSE RAFI
came in at 12.29%, beating the S&P 500s 12.05%, while
WisdomTree fell short, posting an average return of 11.71%.
During declines, the FTSE RAFI portfolio posted the worst
result, a 7.11% decline, while the others remained close:
MarketGrader, -6.93%, S&P 500 at -6.82% and WisdomTree
at -6.70%.
The portfolio results for the periods of high and low volatility
play out much the same way as the indexes did.
Risk Vs. Return
The riskiness of the blended portfolios follows with the
previously considered riskiness of the individual indexes.
Looking at standard deviations, the MarketGrader portfolio
had the highest short-term volatility, as measured by daily
and monthly standard deviation. But looked at on a monthly
or an annualized basis, it had either comparable or lower risk,
despite producing the highest long-term return. On an annual
basis, the MarketGrader portfolio had the lowest level of
standard deviation by a signicant factor.
On a short-term basis, the WisdomTree portfolio had the
lowest daily and monthly standard deviations, but had an an-
nual deviation on par with the S&P portfolio. The FTSE RAFI
portfolio had relatively low short-term standard deviations,
but the largest annual volatility (see Figure 20).
Figure 21 plots the risk versus return of the four market
portfolios using daily, monthly, quarterly and annual standard
deviations. The risk is measured on the X axis, and the return
on the Y; the ideal position in the chart is in the upper-left
quadrant. Note the movement of the different portfolios as
the time frame of study changes.

Figure 19: Cumulative Performance Of Index Portfolios,
2003-1H 2008
S&P 500 Index
Index Portfolio
Index Portfolio
Daily 0.63 0.63 0.73 0.61
Monthly 2.54 2.69 2.94 2.52
Quarterly 5.21 5.65 5.30 5.32
Annual 8.00 9.03 6.92 7.95
Figure 20: Standard Deviation Of Daily, Monthly And
Yearly Returns: 2003 1H 2008
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
Figure 21: Risk Vs. Return Charts Across Four Different Measurement Standards:
Daily, Monthly, Quarterly And Annual (20031H 2008)
0.6 0.62 0.64 0.66 0.68 0.7 0.72 0.74


2.4 2.5 2.6 2.7 2.8 2.9 3



Daily Risk vs Return: 2003 -1H2008 Quarterly Risk vs Return: 2003 -1H2008
Monthly Risk vs Return: 2003 -1H2008 Annual Risk vs Return: 2003 -1H2008
5.1 5.2 5.3 5.4 5.5 5.6 5.7


6 6.5 7 7.5 8 8.5 9 9.5


Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
This paper aimed to determine if in fact the benets claimed
by the creators of fundamental indexes hold up to scrutiny
under recent market conditions.
The claim that fundamental indexes perform better during
value markets, while market-cap-weighted indexes perform
best in growth markets, was proven true. All the fundamen-
tal indexes posted total average returns that outperformed
the S&P 500 during value markets. During growth markets,
the WisdomTree and FTSE RAFI indexes did worse than the
market-cap benchmark. The big surprise was that the stock-
picking MarketGrader index posted a total average return that
outperformed all its peers both in value and growth markets.
In periods of signicant rallies and declines, the results of the
fundamental indexes proved mixed. The MarketGrader index
posted the best average return during market rallies, while
the WisdomTree index posted the best average return during
market declines. The most surprising data here was that the
FTSE RAFI 1000, which claims to outperform market-cap
indexes during bear markets by 580 basis points, actually
posted the worst total average results during periods of sig-
nicant market declines [Arnott et al.]
While no specic claims have been made about the perfor-
mance of fundamental indexes during periods of high or low
market volatility, we decided to evaluate their performance
during these periods. Using the VIX as the benchmark for
volatility, the MarketGrader index once again signicantly
outperformed all its peers during periods both of high volatil-
ity and low volatility.
The portfolio analysis followed the expected results, given
the total gross performance of each of the indexes. The port-
folio holding the SPA MarketGrader ETF posted a higher stan-
dard deviation than the other portfolios, signifying a riskier
portfolio; at the same time, this was more than compensated
for by stronger returns.
The underperformance of the WisdomTree and FTSE RAFI
indexes resulted from the specic portfolio tilts those funds
are forced to take as a result of their methodology. Notably,
the emphasis on dividends as a key metric in both portfolios
encouraged them to make high concentrations in the tail end
of our study period to Financials, which led to under-perfor-
mance when that sector encountered difculty.
By overweighting certain sectors almost as a rule, these
portfolios take on certain risks against a market-cap index
portfolio, which can manifest themselves if those sectors
encounter a period of sustained underperformance.
That doesnt mean that those indexing strategies are wrong.
It just means that they arent right for every condition. In this
case, the enhanced exibility of the MarketGrader indexes
appears to have allowed them to navigate around the difcul-
ties in the Financials sector, and to outperform in both growth
and value markets. Its not certain that they will be able to do
so in the future, but the recent performance has been good.
Fundamental Indexes Comparing The Performance Of Different Fundamental Strategies In Different Market Environments
iNdEx rEsEArch grOuP
This paper was prepared for SPA ETFs by Index Research Group, the leading
provider of custom white papers to the exchange-traded fund and ETF industries.
The opinions expressed herein do not necessarily reect the opinions of Index
Research Group or its parent company, Index Publications LLC.
The paper was written by Lawrence Carrel.
For more information, contact:
Index Research Group
419 Lafayette Street, 3rd Floor
New York, NY 10003