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(This report was posted on November 5, 2007)

FUNDAMENTAL INDEX REVIEW

Robert O. Welk RowTek Economics

Exchange Traded Funds are essentially index-tracking mutual funds. However, whereas mutual funds are valued daily at the close of trading, ETF’s are traded throughout the day like shares of stock.

ETF’s are created when a stockbroker acquires a group of stocks that match an index, or represent an industry, commodities, currencies, countries, or any logical combination. These stocks are then provided to a custodian who issues representative ETF shares to the stockbroker. The ETF shares are then sold to investors and from then on they are bought and sold like other financial instruments.

Even though not referred to as ETF’s at the time, Diamonds and SPDR’s were the genesis of them in the early 1990's. Diamonds tracked the Dow-Jones 30 and SPDR’s the Standard and Poor 500. Investment in ETF’s has grown rapidly during the past five years. In 2002, about $100 billion was invested in them - presently about $500 billion is invested. The financial pages now regularly report activity on 577 ETF’s.

Most stock price indexes, such as the S&P 500 use capitalization weighting. A company is weighted in the index by the number of shares outstanding times their market price. In 2005, research was published on an alternate way to weight companies in indexes. This research proposed weighting by more basic, or “fundamental” measures such as, sales, earnings, dividends, book value, etc. One of the first fundamental ETF’s to become available was the PowerShares FTSE RAFI 1000 US index. This ETF began trading at the end of December 2005. On June 28, 06 I prepared a study (follows this) which back-tested this index versus the S&P 500.

This chart compares the 96 weeks of actual data for this fundamental index versus the S&P 500. The base point in the comparison is the first week of January 2006. The comparison using actual data presents a dramatically different result from the back-tested data. Those data showed that, relative to the market peak in August 2000, the fundamental index was up 47% in June ‘06, while the S&P 500 was minus 16%, (a disparity of 63 percentage points). As shown by this chart, the PowerShares index has tracked the ups and downs of the S&P 500 very closely but has not pulled away from it in a positive way. Relative to the first week of Jan. ‘06, the S&P 500 was up 20% in the week ended Nov.2, ‘07. The PowerShares index was up 23%. The most that the fundamental index improved on the S&P was 5.4% points in both the week ended Mar. 2 and June 29, ‘07. With only 3 points separating them presently, it means that between the weeks ended June 29 and Nov 2 the fundamental index under-performed the S&P.

I feel the results shown here substantiate the theory behind fundamental indexes. The fundamental index theoretically measures true values while cap-weighted indexes are influenced by insubstantial and ephemeral factors. The P/E ratio may be a proxy for true value versus unrealistic value. In the years following the peak in the bubble, the S&P 500 P/E ratio declined steadily from unrealistically high levels (34 in ‘01 down to 20 in ‘05). The decline in ratios put that index at a disadvantage to a fundamental index. Presently, the P/E ratios are closer and have been fairly stable. The PowerShares ratio is 15.4. The S&P ratio as of October 31, ‘07 is 18.2. In conclusion, fundamental indexes are more stable, and have less risk, when the market overall is reflecting unfounded expectations.

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(June 28, 2006)

FUNDAMENTAL INDEXES

Robert O. Welk RowTek Economics

On June 14, 2006 an article by Jeremy Siegel, professor at the Wharton School, appeared on the editorial page of the Wall Street Journal. It was entitled “The Noisy Market Hypothesis”. The title was a spoof on the Efficient Market Hypothesis which postulates that, at any given time, the market price of an equity is the best estimate of the “true” value of that company. A number of economists have questioned the validity of the EMH in research studies. In reality, stocks may be overvalued or undervalued as indicated by a great range in price/earnings ratios. Siegel refers to the publicity, media hype, or whatever that causes a stock price as not representative of the company’s “real” value as noise. Thus, the Noisy Market Hypothesis.

The purpose of the article was to discuss a recent development in the weighting of stock indexes. Most indexes, such as the S&P 500, Russell 1000, Wilshire, and many others weight companies in the index by their market capitalization. Stocks that for various reasons may be overvalued are weighted more heavily than stocks that are undervalued relative to the fundamental value of that company.

Robert D. Arnott, editor of the Financial Analysts Journal, and chairman of Research Affiliates, along with Research Affiliates colleagues Jason Hsu, and Philip Moore published research in the March/April 2005 Financial Analysts Journal on weighting stock indexes with fundamental measures. In their research they developed stock market indexes by weighting companies by fundamental values such as: book value; operating income; revenues; sales; gross dividends; and employment. In addition to those individual indexes they developed a composite index weighted by book value, revenues, operating income, and dividends. They back-tested these indexes for 42 years beginning with 1962. All of the indexes bettered capitalization weighted indexes, from 1.64 to 2.5 percent per year. The average for all the indexes was better by 2.13%. They were less volatile, and did not react to bear markets as severely as the cap indexes. The researchers also tried the approach for other countries and found similar improvement.

A number of companies that supply Exchange Traded Funds for investment have started to provide fundamental-weighted indexes for investment purposes. One of the first was started by PowerShares. The FTSE RAFI US 1000 index is comprised of 1000 companies with composite weights based on: book value; income; sales; and dividends. It began trading on December 19, 2005. Its symbol on the NYSE is PRF. The chart below back tests the index against the S&P 500. The fundamental index was converted so that the index value equaled that of S&P 500 on August 2000, the peak month of the recent stock market bubble.

Compared to August 2000 the S&P 500 in June 2006 is minus 16%, whereas the FTSE 1000 is plus 47%. During the bubble collapse the S&P declined for 30 months by 44%. The FTSE, on the other hand, started its decline 19 months later, dropped for 11 months, and by only 26%.

Siegel is an adviser to WisdomTree, a company that also supplies exchange traded funds. Siegel argues that the best single fundamental value for weighting purposes is gross dividends. To quote him from the WSJ article, “Dividends are the only fundamental variable that is completely objective, transparent and unable to be manipulated by managers who tinker with accounting assumptions.” Just within the past two months WisdomTree has started 17 funds all weighted by dividends.

The major criticism of fundamental indexes offered by the publishers of present cap-weighted indexes is that they promote value over growth. Time will be required to determine whether the results shown by backtesting will continue in the future.

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