Fundamental indices perform better in emerging markets

Fundamentally weighted indices perform better in emerging markets than capitalisation weighted indices, according to Research Affiliates chief investment officer Jason Hsu.

The fundamentally weighted FTSE RAFI Emerging Market (EM) index has produced a 6.5% out-performance per annum against the MSCI EM index in the last five years, says Hsu.

He says the fundamental methodology thrives on market price inefficiencies, whereas the capitalisation weighted indices typically give greater exposure to the more over-valued stocks.

Hsu explains fundamental indices are not influenced by price, meaning there is no correlation between weights and the random mistakes prices can make.

He adds: "In emerging markets, where miss-valuation is the greatest, it is essential to break the price link with the index portfolio weights."

Fundamental indices also preserve liquidity as they take into account weighting metrics that are generally related to the investment capacity of the stock. Hsu says: "These weighting metrics are also specifically chosen and designed to not be correlated with prices and therefore price mistakes."

Nonetheless, there is a need for education as to how fundamental indices are constructed.

Tim Mitchell, head of listed fund sales at Invesco Perpetual, says: "These types of indices are more popular in the US, where indexation is more developed, but it's filtering over to Europe now. However, we are in an education game."

He says PowerShares is now the only UK provider of UK-listed FTSE RAFI funds, after Lyxor de-listed its RAFI offering from the London Stock Exchange earlier this year.

The Research Affiliates Fundamental Index (RAFI) strategy uses four metrics, to offer diversification and level the biases associated with any particular metric. Hsu says mainstream accounting variables are used, where the level of data quality is high.