This is the first of a two part series on fundamentally-weighted portfolios. Please return next week for Part 2.

With the Magnificent 7 stocks now representing close to 35% of the S&P 500, it might be a good time to review how these indexes are composed. If you are in the Financial Independence (FI) community, you are most likely familiar with market capitalization (cap-weighted) indexing, an approach used in major benchmarks like the S&P 500 (VOO) and the US Total Market Index (VTSAX). Market capitalization indexes assign weight to companies based on their total market value, calculated by multiplying outstanding shares by the current share price, meaning that companies with larger market capitalizations exert a greater influence on the index’s performance. The simplicity and low cost of implementation have contributed significantly to the widespread adoption of market cap index funds.

However, an alternative approach, known as fundamentally weighted portfolio allocation, may have some advantages over market capitalization. This strategy diverges from market price-based weighting, instead seeking to allocate capital based on a company’s underlying economic footprint or fundamental strength. In this post, we’ll explore the rationale behind fundamentally-weighted asset allocation, delving into its theoretical underpinnings, empirical evidence, and practical considerations for investors. In Part 2, we’ll also provide a simplified “earnings-weighted” strategy for investors with limited fund options.

The Pitfalls of Market Capitalization Weighting

Market capitalization weighting operates on a simple principle: the larger a company’s market value, the greater its influence within the index. While this approach is simple to implement, and therefore can have very low fees, it is not without its disadvantages. Some of the core issues with market cap weighting are discussed below:

• Diversification mirage: Critics contend that market cap weighting can present a skewed representation of the market, as it inherently overweights companies whose stock prices may have become inflated or overvalued by market sentiment. This dynamic can create concentration risk, where the overall performance of the index becomes disproportionately reliant on a select few large corporations. For instance, the substantial weight of the “Magnificent Seven” stocks (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta Platforms) on the S&P 500’s recent performance illustrates how such concentration can reduce overall portfolio diversification. 
• A disconnect from fundamentals: Academic research by Research Affiliates illustrates the limitations of market capitalization-weighted portfolios, suggesting they can be sub-optimal under certain conditions.  Their research implies that market prices can be “noisy,” not consistently reflecting a stock’s true fair value, and creating what is called “return drag” that is directly proportional to the degree of price inefficiency present in the market.
• Or worse than that, market capitalization indexing might not just reflect market inefficiency, but might be exacerbating it. Recently, academics and finance professionals have been warning that popular index strategies could be creating a self-reinforcing feedback loop where passive inflows perpetuate existing price trends, potentially increasing inelasticity and reducing market efficiency. One of my favorite authors Larry Swedroe recently wrote about this issue over at Alpha Architects. Mike Green has also talked and written about this extensively. 
• Cyclical vulnerabilities: While cap-weighted indexes have experienced strong performance in recent years, assuming this trend will continue indefinitely is not a foregone conclusion. Market-cap weighting can specifically underperform when large, dominant companies experience significant declines in value or when smaller companies achieve stronger performance. Exclusive reliance on cap-weighted indexes entails accepting inherent cyclical vulnerabilities and potentially prolonged periods of underperformance relative to alternative strategies, depending on the prevailing market conditions.

In the next section we’ll discuss some alternatives to market cap weighting, their benefits and risks and how they might be implemented in a portfolio.

Fundamentally Weighted Portfolios

Alternatives to market cap weighting can be fairly simple, like an equal-weighted index, or more complex like a fundamentally weighted index. Equal weighted indexes, while they are not the focus of this post, assign equal weighting to each security within the index. A popular ETF using this strategy is RSP from Invesco. Equal-weighted portfolios have historically yielded higher returns than their cap-weighted counterparts, often attributable to their increased exposure to size and value factors.

Fundamentally weighted indexes, on the other hand, sever the link between a company’s stock price and its weight in the portfolio. Instead, these indexes utilize objective financial measures of a company’s size or economic footprint to determine portfolio allocation.  These metrics may include adjusted sales, retained operating cash flow, dividends plus buybacks, free cash flow, earnings, and book value. To smooth out short-term variability and reduce potential index turnover, multi-year averages, often five-year averages, are frequently utilized for these measures.

Here are some of the key benefits of fundamentally-weighted indexes over market cap weighted index, including some reasons why we should expect fundamentally weighted portfolios to offer a better risk-return profile:

• Balance and diversification: By prioritizing economic strength over market price, these strategies can significantly reduce the risk of becoming entangled in market bubbles fueled by overhyped stocks. This approach breaks the direct link between price and portfolio weight, enabling exposure to companies based on their economic footprint. Fundamental weighting often leads to a more balanced and diversified portfolio composition compared to the concentrated exposures frequently observed in cap-weighted indexes.
• Capturing contrarian investment factors: Fundamental indexes tend to tilt towards desirable investment factors such as value and yield, while exhibiting less susceptibility to a growth bias. This means they are predisposed to overweight undervalued companies and underweight overvalued ones, effectively embedding a “buy-low, sell-high” strategy within their construction. 
• Tuning out the noise: Fundamentals, especially when smoothed out over multiple market cycles, imply that stocks should have far less volatility than they do. By weighting allocations based on fundamentals, you can avoid overweighting (or underweighting) to one security or another simply because the price has changed. When the security eventually returns to its fundamental value, you can capture the difference. This process may play out over many years, and is subject to irrational exuberance and market panics that are all too common with fictitious capital, but is available for patient investors. As Benjamin Graham once said, “In the short run, the stock market is a voting machine. But in the long run, it is a weighing machine.”
• Consistent historical performance: Multiple studies indicate that fundamentally weighted portfolios possess a robust track record of outperforming cap-weighted indexes over extended periods with lower volatility. For example, a back-test spanning from 1962 to 2004 demonstrated that a hypothetical US fundamental index generated a geometric average annual return of 12.47%, compared to 10.53% for the S&P 500 over the same period, notably with slightly lower volatility (14.7% vs. 15.1%). This outperformance is particularly useful during times of market underperformance like the first decade of the 21st century. The chart below compares a US Cap Weighted Index to the RAFI Fundamental Index during the period from 2000 to 2010.

The RAFI Index beat the cap weighted index by over 50%. Not bad for a period of time known as “the lost decade.”

Navigating the Risks and Challenges

If you are already sold on fundamentally-weighted indexes, you might want to read ahead. There are some practical limitations and other considerations you should keep in mind before investing:

• Multiple factors required: Fundamentals are not always indicative of future returns and sole reliance on a single fundamental such as Earnings Per Share (EPS) can be problematic. For example, while low EPS can signal that a stock is expensive, it frequently also reflects investor optimism and expectations for robust future earnings growth. EPS and PE ratios provide a limited scope for stock valuation, as they does not fully capture broader market conditions, future growth potential, or how profits are distributed (e.g., dividends), nor does it account for inflation. A robust strategy should ideally incorporate a broader set of fundamental metrics (adjusted sales, retained operating cash flow, dividends plus buybacks, free cash flow, earnings, and book value) and perhaps qualitative analysis to mitigate these risks.
• Tracking error: Despite their long-term potential, fundamentally weighted strategies are not immune to periods of underperformance. They can lag behind market-cap-weighted indexes, particularly during strong bull markets that are predominantly driven by growth stocks or specific sectors (for example, the Mag 7). These strategies often exhibit a value tilt, meaning their performance tends to be cyclical, aligning favorably with value-driven market conditions or the early stages of a business cycle. Conversely, they may underperform when growth stocks are leading the market.
• Implementation hurdles: Fundamentally weighted indexes may require more frequent rebalancing to maintain their desired weights, which can result in higher transaction costs and management fees compared to cap-weighted indexes. While the core concept of fundamental weighting is straightforward, the practical application of using several fundamental metrics and understanding their intricate interactions can render these strategies more complex for individual investors to analyze and manage.
• Unintended risks: By design, fundamental weighting introduces active risk relative to a market-cap benchmark. It inherently tilts a portfolio towards factors such as value, low size (smaller companies), and yield, and may exhibit negative exposure to momentum. This means investors are effectively making a factor bet, which carries its own set of risks and may not always yield superior returns if those favored factors are out of favor.

So far, I’ve discussed the issues with market capitalization as an asset allocation strategy and explored fundamentally-weighted strategies as a possible solution. But given the complexity of market fundamentals, how would anyone go about implementing such a strategy? Next week, we will next discuss how DIY investors can implement fundamental weightings in their portfolio without hours and hours of research.

Until then, hope you are enjoying the end of summer!