May 27, 2014

As of year-end 2013, approximately $175 billion was committed to fundamental investment strategies and so-called “smart beta” or “alternative beta” implementations (according to ETF.com). But whether these strategies and implementations are basing their index weights on corporate fundamentals such as book value or earnings or dividends, their products outperform traditional capitalization weighted indexes primarily due to portfolio construction.

Fundamental indexing and smart beta approaches have many shortcomings:

(1) They are style and size biased, favoring smaller and more value-oriented names;

(2) They offer limited diversification benefit as their returns are still highly correlated with traditional capitalization weighted indexes;

(3) Their volatility is driven by the share price of the underlying holdings.

Ultimately, even smart beta is still beta, and fundamentally weighted portfolios still deliver returns distorted by extrinsic factors and market noise.

Fundamental Indexing
The concept of fundamental indexing was introduced in mid-2004 by Rob Arnott, Jason Hu, and Philip Moore in their paper entitled “Fundamental Indexation”. The research behind fundamental indexing found that by weighting stocks in the index by fundamental characteristics instead of market capitalization, investors can outperform the traditional cap-weighted S&P 500 Index by approximately 2% over a 43-year period. That 2% alpha, when compounded over time, doubled the size of the investor’s portfolio in 35 years.

The fundamental factors explored in Arnott’s initial research included: book value, cash flow, revenue, sales, and dividends. One of the goals of weighting by fundamentals instead of market capitalization is to take price out of the equation. By definition, a stock’s market capitalization is the share price multiplied by the free-float shares outstanding. Critics of fundamental indexing argue the phenomenon being exploited is actually style and size bias. Fundamental indexes are tilted toward small cap and value stocks, which have historically outperformed.

As demonstrated below, even a naïve equal-weighted approach outperforms the traditional capitalization weighted index. Comparing the historical monthly returns of the S&P 500, S&P 500 Equal Weighted, and FTSE RAFI US 1000 indexes as proxies for capitalization index weighting, equal index weighting, and fundamental weighting schemes, both equal weighted and fundamental index approaches produce superior historical returns than traditional capitalization weighted approaches.


Indexed to 100 from January 4, 1999, through December 31, 2013. Past performance does not guarantee future results. Source: Bloomberg, Reality Shares Research

In recent years, fundamental indexing has been reclassified in the marketplace as alternative or smart beta. The research for sources of alternative beta has been extended to include:

(1) Heuristic-based weighting methodologies – rules-based weighting schemes such as equal weighting, diversity weighting, and fundamental weighting.

(2) Optimization-based methodologies – portfolios constructed based on minimum variance, maximum diversification, and risk-weighting.

Our Assessment of Fundamental Indexing and Smart Beta
We argue each of these alternatively weighted index implementations, whether labeled fundamental indexing or smart beta, is inherently flawed. To quote Craig Lazzara with S&P Dow Jones Indices, “when you change the factors of an index, you simply change how it will perform in different market conditions.” Although fundamental indexing and smart beta approaches attempt to sever the link with price by avoiding market capitalization, both of these approaches are still correlated with price.

We believe price is a destabilizing influence on the portfolio, and exposure to price limits diversification in an overall asset allocation scheme. Our approach takes fundamental indexing and smart beta strategies to the next level by truly separating underlying fundamentals such as dividend growth from price volatility and market noise.

By utilizing investment instruments such as dividend swaps, futures, forwards, and options, we can construct index vehicles that isolate the underlying dividend growth of a company or index, while mitigating the influence of price. This isolation method allows investors to reduce extraneous systematic market risk (beta) and explicitly participate in the underlying fundamental components of a company or basket of companies.

We have designed a series of Reality Shares Indexes to achieve a high correlation with underlying corporate fundamentals and a low correlation to the market noise and volatility associated with price-based indexes.

In subsequent articles in this series, we will explore some of the strategies available to segregate fundamentals from price (the “how to”) and explore what advantages these approaches offer relative to fundamental indexing and smart beta implementations (the “why”). We will also offer some ideas (the “where”) on how these products might fit in your overall asset allocation plan in order to capture an uncorrelated source of return.


S&P 500: A broad stock market index based on the market capitalization of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 was developed and continues to be maintained by Standard & Poor’s Financial Services LLC, and is considered to be a bellwether for the US economy. S&P 500 Equal Weighted Index: The equal-weight version of the S&P 500 index, where each company is allocated a fixed weight of 0.2% of the index total at each quarterly rebalance. FTSE RAFI US 1000 Index: Comprised of the 1,000 U.S.-listed companies with the largest RAFI fundamental scores as determined by Research Affiliates. Minimum Variance Portfolio = The optimal portfolio in a world with zero risk premium.

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Investments in options, swaps, forward contracts and futures contracts are subject to a number of risks, including correlation risk, interest rate risk, market risk, leverage risk, and liquidity risk. Each of these risks could cause the Fund to vary from its stated objective, could cause the Fund to lose money and may have a negative impact on the value of your investment. Please refer to the Fund Risks for further explanation of individual risks.

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Reality Shares Advisors, LLC is the Investment Advisor. ALPS Distributors, Inc. is the Distributor for the Fund. Reality Shares Advisors, LLC and ALPS Distributors, Inc. are not affiliated.

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