About ten years ago, Rob Arnott, Chairman of Research Affiliates, introduced Fundamental Indexing as an alternative to traditional capitalization-weighted indexes. Arnott argued that almost any other weighting scheme would produce better performance. So for the first time ever, we had indexes that are designed to outperform. All other indexes are designed to match the performance of an entire market or a market segment.

Fundamental indexing has attracted hundreds of billions of dollars, and has become one of the hottest investments around. You may have heard of them as “RAFI” indexes, which stands for Research Affiliates Fundamental Indexes, or as “Smart Beta” indexes, a name Rob Arnott has popularized.

Kudos to Rob for coining the phrase “Smart Beta.” Everyone wants to be smart. Indexes that use fundamental weightings, rather than capitalization weightings, are deemed to be smart by Mr. Arnott because they are predicted to perform better.

Fundamental (smart beta) weights typically tilt toward value and smaller companies relative to their cap-weighted counterparts, and this tilt has a track record of performing better, so it may indeed be smart. Fundamental indexes are usually created for broad markets, like the U.S. or Europe, but PowerShares recently introduced fundamental style indexes called “Fundamental Pure Style Indexes”, or FPS.

FPS indexes are indeed smart on one important count. They are mutually exclusive and exhaustive, mirroring the familiar 3 X 3 structure of the Morningstar style indexes, which are derived from the Surz Style Pure® indexes I developed in the 1980s. (See chart below.)

Surz

Mutually exclusive and exhaustive is smart for both returns-based and holdings-based style analyses, and also for portfolio construction. They make good building blocks.

There are only three such families of style indexes: FPS, Morningstar and Surz. Unlike all other indexes, these three families provide a “Centric Core”, defined as the stocks in between value and growth. All other style index families split these centric stocks into both value and growth, leading to a lack of style purity, hence the word “Pure” in my index name.

One of the nine indexes in my style index family is especially valuable. Surz Style Pure Large Cap Centric Core makes a great diversification partner for active managers, and is available on Covestor to round out your investment program. By adding companies your active managers generally don’t hold, as little as 15% in Centric Core improves diversification and risk-adjusted performance,

Not so Smart

Style indexes are used in portfolios as completeness funds and to make style bets, like style rotation approaches. They are used in tandem with other investments, like active managers, to add value. As such, you’d prefer your indexes to be different from one another. Therein lies the flaw in FPS. The FPS indexes are tilted toward value, so they are more clustered than Surz Style Pure indexes, as shown in the following exhibit. Also, FPS core is not in between value and growth, which is puzzling.

FPS uses characteristics that are similar to mine to categorize stocks as value, core or growth, but my indexes are capitalization-weighted whereas FPS weights by combining four factors: sales, cash flow, book value, and dividends.

The FPS weights move the indexes toward value since these weights are value-oriented attributes.  In other words, the individual stocks in our indexes are similar, but the allocations to those stocks are substantially different. My weights are style preserving, while fundamental weights pervert style by moving the index toward value.

Surz2

FPS might beat my indexes on occasion, but they don’t provide the benefits that most expect from style indexes, namely completeness or style concentration. The fact is that the FPS value-core-growth indexes are almost identical. The value tilt pushes them all to the left, toward value.

Conclusion

Sometimes a good idea has its limitations. Extending fundamental weightings to style indexes is not a good idea.  Value-tilted growth is dumb.

So what does this mean to you? Style investing is very popular, as is fundamental indexing. Be careful about your choice of style index family and the reason you’re using style indexes. Fundamental style indexes are not a good choice for most applications.