Fundamentally Weighted Index: How it Works, Examples

What Is a Fundamentally Weighted Index?

A fundamentally weighted index is a type of equity index in which components are chosen based on fundamental criteria instead of market capitalization. It can be based on metrics such as revenue, dividend rates, earnings, or book value. Fundamentally weighted indexes serve as benchmarks for passively managed funds that provide exposure to stocks based on fundamental characteristics.

Key Takeaways

• A fundamentally weighted index, or fundamental index, selects equity components based on criteria other than market capitalization.
• For example, a fundamentally weighted index can be based on revenue, dividend yields, earnings, or other fundamental factors.
• Fundamentally weighted indexes are commonly used by passively managed tracker funds.

How Fundamentally Weighted Indexes Work

Fundamentally weighted indexes gained popularity due to investor interest in passive management. They gained prominence after Research Affiliates introduced research on them in 2004. Interest in these indexes has continued to grow as more fund companies create customized indexes that represent specific investment aspects of the market.

Fundamentally weighted indexes are part of a new wave of tracker fund offerings. These passively managed index funds go beyond mainstream offerings by replicating customized indexes based on various characteristics.

Fundamentally weighted indexes are commonly used by passively managed tracker funds. Fund companies often create their own fundamental indexes to build portfolios and issue structured funds to the public. By using these indexes, investment companies can reduce costs and improve efficiency through lower transaction expenses and annual rebalancing.

Proponents of these indexes claim that they provide higher potential returns based on aggregate fundamental measures of the market. They can be constructed using a range of successful metrics in identifying top-performing investments over time. Typically, investors who prefer these indexes are more avid and interested in weighted strategies.

Example of a Fundamentally Weighted Index: FTSE RAFI

The Financial Times Stock Exchange (FTSE), in partnership with Research Affiliates, offers many fundamentally weighted indexes. These indexes are weighted using fundamental factors such as total cash dividends, free cash flow, total sales, and book equity value.

The Invesco FTSE RAFI U.S. 1000 ETF is one fund managed to the FTSE RAFI Index. The fund aims to replicate the holdings and performance of the FTSE RAFI US 1000 Index.

Wisdom Tree Customized Fund Offerings

Wisdom Tree is a fund provider that specializes in offering fundamentally weighted proprietary indexes. The firm’s domestic quality equity ETFs provide investors with three passively managed fundamentally weighted index portfolios, including WisdomTree U.S. Quality Dividend Growth Fund (DGRW), WisdomTree U.S. Small-Cap Quality Dividend Growth Fund (DGRS), and WisdomTree U.S. Quality Shareholder Yield Fund (QSY).

Wisdom Tree is a fund provider that specializes in offering fundamentally weighted proprietary indexes. The firm’s domestic quality equity ETFs provide investors with three passively managed fundamentally weighted index portfolios, including WisdomTree U.S. Quality Dividend Growth Fund (DGRW), WisdomTree U.S. Small-Cap Quality Dividend Growth Fund (DGRS), and WisdomTree U.S. Quality Shareholder Yield Fund (QSY).