Market efficiency lies at the heart of the Fundamental Index^® debate.

Advisors and consultants have long advocated that market efficiency varies by equity market segment, with U.S. large companies being among the most efficient and emerging markets among the least efficient.

Factors influencing the extent of mispricings within these markets include the flow and availability of information, analyst coverage, transaction costs, and the sophistication of local investors.

In this issue we discover that the expected value added from the Fundamental Index strategy rises in inefficient markets, making it an attractive alternative to traditional active management.

By construction, stocks that trade above their eventual (but currently unknowable) fair value will comprise a larger portion of the cap-weighted index. Meanwhile, shares priced below fair value will comprise less of the cap-weighted index. As the overpriced subsequently underperform, their relative losses overwhelm the underpriced shares' outperformance because the overpriced comprise more of the portfolio. The resulting return drag was documented to be over 2% per annum in our original research on U.S. large companies.¹ The Fundamental Index concept was designed to eliminate this return drag by weighting stocks by financial measures of firm size.

U.S. large companies are largely considered the most efficient stocks. An extraordinarily mature market, accurate data on these companies extends back at least 40 years and is easily accessible from even widely used public Internet portals. Further, these companies receive the most research coverage-witness the 30-plus analysts on Wall Street that follow Intel with its $125 billion market cap versus the 3 analysts that research small-cap Avista Corporation (a $1 billion market cap Northwest utility). Transaction costs are low and liquidity high in large-cap companies, ensuring that traders can move quickly and efficiently to correct perceived mispricings. Other developed country equity markets are similarly efficient.

As we move away from large-cap, developed country equities, the various "frictions" increase and result in less-efficient pricing of individual securities. The result is mispricings that are wider in magnitude. What happens to a cap-weighted index in such markets? Because weights are linked to price, even more weight is allocated to the overvalued and even less to the undervalued stocks. In this manner, as seen in Figure 1, the return drag from cap weighting rises in less-efficient markets.

Figure 1. Return Drag of Cap-Weighted Indices

Source: Arnott, Robert D., and John M. West. 2006. "Fundamental Indexes:
Current and Future Applications." A Guide to Exchange Traded Funds and
Indexing Innovations-Fifth Anniversary Issue. Institutional Investor,
(Fall): 111-121.

Inefficient markets such as small-cap stocks and emerging markets also exhibit a higher frequency of mispricings. A greater number of stocks can be expected to be priced well above (below) fair value at any given point in time. With so many mispriced shares continuously reverting toward fair value, the return drag from cap weighting becomes more reliable in less-efficient equity segments. These markets aren't dependent on a few big bubbles to generate excess returns as some critics assert.

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