How to Implement a Fundamentally-Weighted Strategy

Last week, we discussed the issues with market capitalization-weighted asset allocation and the potential for better risk-adjusted returns using what is called fundamentally-weighted asset allocation. This week we’ll discuss a few ways to implement these strategies in your portfolio.

If you are interested in fundamental weighting, several prominent asset management companies have created fundamentally-weighted index funds. Many of these funds are based on the FTSE RAFI series of fundamental equity indexes, which have been compiled in collaboration with Research Affiliates since 2005. These indexes are constructed using a combination of four core fundamental measures: sales, cash flow, book value, and dividends.

Charles Schwab offers a suite of Fundamental Index Funds that track various RAFI indexes across different market segments, including US Large, US Small, International, Emerging Markets, and Real Estate. Invesco offers the RAFI US 1000 ETF (PRF) and PIMCO offers a series of Multi-Factor ETFs built using RAFI indexes. Most of these are listed on the Research Affiliates Website.  If you are interested in trying a different approach, WisdomTree has pioneered a set of fundamentally weighted index funds, with a focus on quality dividend growth and shareholder yield.

Unfortunately, many employer-sponsored 401Ks and retirement investment vehicles may not have access to the RAFI funds or any other fundamentally-weighted index funds. A DIY investor might be left investing in an index or target date retirement fund and hoping for the best.

First though, let’s consider if we could apply the basic concepts of fundamental weights to an asset allocation consisting of multiple cap-weighted index funds. The most straightforward approach might be to look at the fundamentals of a US market cap fund and compare them to those of a broadly diversified international fund. Research suggests, for example, that the Shiller PE or CAPE ratio is a good fundamental predictor of long-term (10-15 year) stock market returns. 

Here I’ll use the S&P 500 as a stand-in for the total US market and the developed ex-US market as a stand-in for the rest of the world (Admittedly, not perfect but close enough for the exercise). The market cap weightings were pulled from companiesmarketcap.com and the CAPE ratios from public databases at the end of June 2025. As you can see, the CAPE ratio of the two asset classes are significantly different:

Metric	S&P 500	Developed Ex-US Equities
CAPE Ratio	36.06	19.30
CAEY	2.75%	5.09%
10-Year TIPS Yield	2.01%	2.01%
Equity Risk Premium	0.74%	3.08%

As I wrote about previously, the CAPE ratio is the current price of a broad stock index divided by the average of its inflation-adjusted earnings over the past ten years. Because the numerator represents price and the denominator represents earnings, if we invert the CAPE, we get the cyclically adjusted earnings yield (CAEY).

You could think of the CAEY as the amount of inflation adjusted earnings from each $100 invested. This means that for every $100 we invest today in the S&P 500, the companies that make up the index have earned $2.75 in earnings, while the developed ex-US companies have earned $5.09 for every $100 invested.

Using the market cap weightings and doing a little math, we can figure out approximately what percentage of total world corporate earnings came from the US. For example, let’s say we invested $100 in a global basket of stocks according to their market cap weights, yielding $3.88 in earnings. With the US making up about 52% of the world’s equity market capitalization, that equates to $1.43 in earnings from the US (37% of global earnings) and $2.45 from International (63% of global earnings). 

Instead of using market capitalization, what if we used an earnings-weighted allocation defined by the proportional earnings share of the global market? This would mean allocating roughly 37% to US and 63% to International. The simple intuition behind this choice is that, if the US represents 37% of total global earnings, why would you want to allocate your investments any differently? The only reason they represent a higher portion of a cap-weighted portfolio is because their valuations are higher. 

Because this strategy allocates based on the inflation-adjusted 10-year average earnings from each asset class instead of the market cap, the relative allocations are unlikely to shift as rapidly as a market cap weighted portfolio. If and when the tables turn and US prices dip compared to Ex-US equities (or at least not as much), the Shiller PE on the S&P 500 will go down, but so will the market cap weightings for US stocks. These two factors will tend to cancel each other out, unless the relative earnings share or currency valuations change.

However, since your US fund is market cap weighted, it will likely need to be rebalanced with the Ex-US fund to retain your target allocations. This means you would be selling one fund (with a rising CAPE value) and buying into the other fund (with a falling CAPE). In this sense, the strategy is contrarian, following the age old advice of buy low, sell high. But, because it is mechanical, rules based and gradual, it doesn’t require clairvoyance or jumping in and out of the market. 

You could in theory apply this methodology to other equity asset classes as well, but you would need to know the asset class’s Shiller PE or earnings yield, and its relative contribution to the global equity market cap. The Shiller PE or CAPE ratio for various asset classes is available on Research Affiliates Asset Allocation Interactive, but the market cap share is a little harder to come by. If you used this approach for small caps and emerging markets, for example, you would definitely want a source that gets updated frequently, so you can make sure your allocation doesn’t get out of date.

Some final notes: You might consider weighing this approach against the minimum variance strategy I described in my series on the CAPE ratio and the Merton Share. The minimum variance portfolio is roughly the opposite of an earnings-weighted portfolio: 60% US / 40% International. The earnings-weighted approach (at least historically) is likely more volatile. Here is a chart comparing the three strategies and their weightings.

If you want to try out this approach, you can check out this Google Sheet I made that automatically adjusts the asset allocation between US stocks, international stocks and bonds. The calculator combines what we learned about the Merton Share a few weeks ago with the market-aware strategies described in this post. It now includes a selector for the geographic allocations so you can choose between market capitalization, minimum variance and earnings weighted strategies.

Conclusion: Is Earnings Weighting Right for Your Portfolio?

While market capitalization weighting remains the default approach for many investors, it carries inherent biases and risks, particularly concentration and a propensity for overvaluation driven by market sentiment. Fundamentally-weighted portfolios offer a compelling alternative, aiming to allocate capital based on a company’s underlying economic reality rather than its fluctuating market price. This approach often leads to long-term outperformance and an inherent tilt towards value factors.

However, it is crucial to acknowledge that this strategy is not without its challenges. Investors may experience periods of underperformance, particularly during bull markets dominated by growth stocks. Higher costs associated with more frequent rebalancing and potentially increased volatility are also considerations. Nevertheless, fundamentally-weighted asset allocations are research-backed and align with principles aimed at mitigating common market inefficiencies. Ultimately, the suitability of this approach depends on an investor’s individual goals, risk tolerance, and time horizon. Regardless of the chosen weighting methodology, a thorough understanding of the underlying principles and the rationale behind your holdings remains paramount for long-term investment success.