Fundamental indexation: rebalancing assumptions and performance

• Index performance is highly sensitive to rebalancing assumptions
• Performance ambiguity is an undesirable feature of an index
• Blending multiple indices can lead to a more robust index

In this article,¹ we show that the performance of a fundamental index with annual rebalancing, as proposed by Arnott, Hsu, and Moore (2005), can be highly sensitive to the subjective choice of when to rebalance. For the year 2009, for example, a fundamental index rebalanced every March outperformed the capitalization-weighted index by over 10%, whereas a fundamental index rebalanced every September underperformed.

We provide intuitive and statistical evidence in support of the hypothesis that if two fundamental indices diverge, they do not subsequently tend to mean revert (i.e., the gap is likely to be permanent). The performance ambiguity is an undesirable feature for an index that is used for benchmarking purposes.

We introduce the idea of blending multiple underlying fundamental indices, each one rebalanced annually but at different dates, as an example of how to construct a more robust fundamental index without increasing turnover.

¹Blitz, D.C., Van der Grient, B. and Van Vliet, P., 2010, ‘Fundamental indexation: rebalancing assumptions and performance’, The Journal of Index Investing.