Fundamental Indexation For Global Equities: Does Firm Size Matter?

Abstract

Market capitalization is often used as the weighting methodology for broad market indexes to reflect the performances of large established firms in the market. The market capitalization of a firm is a price-sensitive measure of firm size that self-adjusts to reflect the firm’s intrinsic value in an efficient capital market. In the presence of investor overreaction, the price-sensitive cap-weighted indexes cease to be mean-variance efficient in that they overweigh overvalued assets and under weigh undervalued assets. Fundamental indexation, proposed by Arnott, Hsu and Moore (2005), argue that fundamental values of a firm such as book value, revenues and earnings are price-insensitive, and hence are not subject to the systematic overshooting of asset prices through noise trading. The aim of this paper is to test whether fundamental-weighted indexes are more mean-variance efficient proxies for large established firms in the global equity market compared to cap-weighted indexes over an extensive 18-year period from 1991 to 2008. Test results show that fundamental-weighted indexes outperform cap-weighted indexes over two sub-periods as well as the overall examination period, during an expansionary market and in turbulent times. A strong negative relationship between the degree of index concentration and the index performance is detected for cap-weighted indexes while no such relationship is detected for the fundamental-weighted indexes. Our results suggest that price-insensitive fundamental-weighted indexes are more mean-variance efficient proxies for the performances of large firms for global equities relative to cap-weighted indexes. By removing the price-element in measuring firm size, the small firm anomaly is not present in fundamental-weighted indexes.