Application of Fundamental Indexation for South African Equities

Abstract

Recent literature suggests that fundamental attributes are better proxies for index construction in contrast to market capitalisation-weighted methods. Arnott, Hsu and Moore (2005) argue that high-priced shares will have the tendency to realise lower risk-adjusted returns, thus a cap-weighted index that places more weight in high-priced shares will experience lower risk-adjusted returns. Hsu and Campolo (2006) find that fundamental indices outperform their cap-weighted counterparts, not due to firm’s fundamental attributes being truer indicators of their share fair values, but merely because the indices are non-price weighted. They argue that cap-weighted indices are price sensitive and therefore experience a performance drag whilst fundamental indices are price-insensitive. The performance drag of price-sensitive indices is considered too be caused by noise variables within share prices due to investor overreaction and overvaluation of growth shares and undervaluation of value shares. he JSE All Share Index (ALSI) is dominated by few large-cap stocks. The primary objectives of this research are to determine whether indices constructed from fundamental attributes of ALSI constituents outperform indices weighted by market capitalisations; and whether the performance of fundamental indices could be explained by size and value risk factors. The examination period is 1st January 2000 to 31st December 2009. The JSE ALSI constituent’s fundamental attributes; book values, dividends, earnings and sales together with their market values are extracted from DataStream International. Indices are subsequently constructed according to share’s market values and the four aforementioned fundamental attributes as well as a composite metric.