|
Everthing You Wanted to Know
About Fundamental Indexing,
but Were Afraid to Ask?
By Carmen Campollo, Sr Vice President FTSE
Fundamental Indexing is a way to invest where an investor would mitigate losses (risk control) in the stock market and maximize returns. As simple as it sounds, this is not the way the average person invests. In the majority of cases, an investor buys mutual funds. These funds in turn include in their prospectus a benchmark or index. This benchmark or index is a parameter that measures how well or how poor the fund has performed throughout time. All the benchmarks until recently were market capitalization indexes or benchmarks (market cap). This means that these indexes used two components in their construction:
1. the price of stocks included in the index and
2. the shares outstanding of each company included in the index.
The weights assigned to each company are based on the market cap, which is price times shares for all companies in their index. The weights of each company in the index is proportional to the sum of all the companies market cap.
At the end of the day, we know that there is a lot of noise and volatility in the market. Martha Stewart goes to jail, her company goes down. Martha Stewart comes out of jail, the price of her company goes up. Therefore, if these are the prices used to calculate the indexes or benchmarks of the mutual funds, we can understand why the market can go up, regardless of the fundamentals of a company.
What this means is that a market cap weighted index will drag your investments up but if there is a market correction, the fall and losses will be drastic.
This won't happen with a Fundamental Indexing approach. The weights of the companies in a Fundamentals Index, are based on the true fair value of the companies and the index does not use prices on its calculation. It uses book value, cash dividends, sales and cash flow. This approach will never force investors to buy more than what the value of the company really is and would never force investors to overweight or underweight their investments, which is a flaw of market cap.
Schwab has launched Mutual Funds for individuals, Investment Advisors and for Institutional Investors using the "Fundamental Indexing" approach.
|
Carmen Campollo
Sr Vice President FTSE
Guest Editor
|
Ask a Fashion Expert!
