Fundamental indexation and mean reversion on the Taiwanese equity market

Abstract

The equity market has a long memory of indexing. The market portfolio is a capweighted index that weights stocks based on the market capitalisation of the stocks constituting the index and has been upheld by modern portfolio theory as the optimal portfolio, generating the highest return for given risk. Justification for the meanvariance efficiency of the market portfolio stems from the assumed efficiency of stock markets. However, Siegel (2006) states that, because of speculative trading in the market, which induces noise in stock prices, the prices of stocks deviate from their intrinsic value. The subsequent reversal of overweighting of overvalued stocks and underweighting of undervalued stocks to their intrinsic values by capitalisation weighting results in a return drag. Recent observations of portfolios constructed based on weighting methodologies other than capitalisation weighting have resulted in portfolios that generate excess riskadjusted returns over and above that of the market portfolio; casting doubt on the assumed efficiency of the market. One such weighting methodologies is fundamental indexation, under which stocks are weighted by their fundamental metrics of size. The concept was introduced by Arnott, Hsu and Moore (2005). Chen, Chen and Bassett (2007) also introduced the concept of smoothed cap weights (SCW) as a more reliable estimate of the intrinsic value of a stock. This research study applies the concept of fundamental indexation and SCW to investigate the relative performance of fundamental indices of different concentrations (top 50 and mid-100 stocks) against cap-weighted portfolios on the Taiwanese equity market. The research period runs from January 2001 to June 2014, using the TEJ database as the data source.