Market-cap-weighting reflects all market participants' views, allowing passive investors to free-ride on the collective wisdom of all active investors. But there is a risk that it could also lead a portfolio to overweight the most expensive areas of the market. Fundamental index funds attempt to circumvent this potential problem by severing the link between a stock's portfolio weight and its price. This article explores the investment thesis of fundamental weighting and examines the investment merits of strategies that use this weighting approach.
Market-cap-weighted indexes are inherently efficient and inexpensive to implement. A stock's weight in a market-cap-weighted index moves with its share price. Investors save on transaction costs because the index's largest positions are naturally the biggest companies with the most-liquid shares. Unlike market-cap-weighted indexes, fundamental indexes size their holdings by metrics such as company revenues, earnings, or dividends instead of share prices.
Adam McCullough, CFA has a position in the following securities mentioned above: VBR VOE. Find out about Morningstar's editorial policies.